A Liquidity Risk Stress-Testing Framework with Interaction between Market and Credit Risks
AbstractThis study develops a stress-testing framework to assess liquidity risk of banks, where liquidity and default risks can stem from the crystallisation of market risk arising from a prolonged period of negative asset price shocks. In the framework, exogenous asset price shocks increase banks¡¯ liquidity risk through three channels. First, severe mark-to-market losses on the banks¡¯ assets increase banks¡¯ default risk and thus induce significant deposits outflows. Secondly, the ability to generate liquidity from asset sales continues to evaporate due to the shocks. Thirdly, banks are exposed to contingent liquidity risk, as the likelihood of drawdowns on their irrevocable commitments increases in such stressful financial environments. In the framework, the linkage between market and default risks of banks is implemented using a Merton-type model, while the linkage between default risk and deposit outflows is estimated econometrically. Contagion risk is also incorporated through banks¡¯ linkage in the interbank and capital markets. Using the Monte Carlo method, the framework quantifies liquidity risk of individual banks by estimating the expected cash-shortage time and the expected default time. Based on publicly available data as at the end of 2007, the framework is applied to a group of banks in Hong Kong. The simulation results suggest that liquidity risk of the banks would be contained in the face of a prolonged period of asset price shocks. However, some banks would be vulnerable when such shocks coincide with interest rate hikes due to monetary tightening. Such tightening is, however, relatively unlikely in a context of such shocks.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Hong Kong Monetary Authority in its series Working Papers with number 0906.
Length: 33 pages
Date of creation: Mar 2009
Date of revision:
Contact details of provider:
Postal: 55th Floor, Two International Finance Centre, 8 Finance Street, Central
Web page: http://www.info.gov.hk/hkma/
More information through EDIRC
Liquidity risk; stress testing; default risk; banks;
Find related papers by JEL classification:
- C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-04-05 (All new papers)
- NEP-CBA-2009-04-05 (Central Banking)
- NEP-FMK-2009-04-05 (Financial Markets)
- NEP-MAC-2009-04-05 (Macroeconomics)
- NEP-RMG-2009-04-05 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2007.
"Network models and financial stability,"
Journal of Economic Dynamics and Control,
Elsevier, vol. 31(6), pages 2033-2060, June.
- Lea Zicchino & Dimitrios Tsomocos & Miguel Segoviano & Charles Goodhart & Oriol Aspachs Bracon, 2006.
"Searching for a Metric for Financial Stability,"
FMG Special Papers
sp167, Financial Markets Group.
- Dimitrios P Tsomocos & O. AspachsC. GoodhartM. SegovianoL. Zicchino, 2006. "Searching for a Metric for Financial Stability," Economics Series Working Papers 2006-FE-09, University of Oxford, Department of Economics.
- O. Aspachs & C. Goodhart & M. Segoviano & D. Tsomocos & L. Zicchino, 2006. "Searching for a Metric for Financial Stability," OFRC Working Papers Series 2006fe09, Oxford Financial Research Centre.
- Acharya, Viral V & Yorulmazer, Tanju, 2005. "Cash-in-the-Market Pricing and Optimal Bank Bailout Policy," CEPR Discussion Papers 5154, C.E.P.R. Discussion Papers.
- Adrian, T. & Shin, H S., 2008. "Liquidity and financial contagion," Financial Stability Review, Banque de France, issue 11, pages 1-7, February.
- Pierre Collin-Dufresne, 2001. "Do Credit Spreads Reflect Stationary Leverage Ratios?," Journal of Finance, American Finance Association, vol. 56(5), pages 1929-1957, October.
- Dimitrios P Tsomocos & Charles A.E. Goodhart, 2003.
"A Model to Analyse Financial Fragility,"
Economics Series Working Papers
2003-FE-13, University of Oxford, Department of Economics.
- Charles A.E. Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2003. "A Model to Analyse Financial Fragility," OFRC Working Papers Series 2003fe13, Oxford Financial Research Centre.
- Charles Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2004. "A model to analyse financial fragility," LSE Research Online Documents on Economics 24703, London School of Economics and Political Science, LSE Library.
- Allen, Franklin & Gale, Douglas, 1994.
"Limited Market Participation and Volatility of Asset Prices,"
American Economic Review,
American Economic Association, vol. 84(4), pages 933-55, September.
- Gale, D. & Allen, F., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 14-91, Wharton School - Weiss Center for International Financial Research.
- Allen, F. & Gale, D., 1991. "Limited Market Participation and Volatility of Asset Prices," Weiss Center Working Papers 2-92, Wharton School - Weiss Center for International Financial Research.
- Douglas W. Diamond & Raghuram G. Rajan, 2003.
"Liquidity Shortages and Banking Crises,"
NBER Working Papers
10071, National Bureau of Economic Research, Inc.
- Adrian, Tobias & Shin, Hyun Song, 2010.
"Liquidity and leverage,"
Journal of Financial Intermediation,
Elsevier, vol. 19(3), pages 418-437, July.
- Goetz von Peter, 2004.
"Asset prices and banking distress: a macroeconomic approach,"
BIS Working Papers
167, Bank for International Settlements.
- von Peter, Goetz, 2009. "Asset prices and banking distress: A macroeconomic approach," Journal of Financial Stability, Elsevier, vol. 5(3), pages 298-319, September.
- Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and financial cycles," BIS Working Papers 256, Bank for International Settlements.
- Edward Altman & Andrea Resti & Andrea Sironi, 2004. "Default Recovery Rates in Credit Risk Modelling: A Review of the Literature and Empirical Evidence," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 33(2), pages 183-208, 07.
- Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
- Briys, Eric & de Varenne, François, 1997. "Valuing Risky Fixed Rate Debt: An Extension," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 32(02), pages 239-248, June.
- Rodrigo Cifuentes & Hyun Song Shin & Gianluigi Ferrucci, 2005.
"Liquidity Risk and Contagion,"
Journal of the European Economic Association,
MIT Press, vol. 3(2-3), pages 556-566, 04/05.
- Michael Boss & Gerald Krenn & Claus Puhr & Martin Summer, 2006. "Systemic Risk Monitor: A Model for Systemic Risk Analysis and Stress Testing of Banking Systems," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 11.
- P. Collin-Dufresne & R. Goldstein & J. Hugonnier, 2004. "A General Formula for Valuing Defaultable Securities," Econometrica, Econometric Society, vol. 72(5), pages 1377-1407, 09.
- Merton, Robert C, 1978.
"On the Cost of Deposit Insurance When There Are Surveillance Costs,"
The Journal of Business,
University of Chicago Press, vol. 51(3), pages 439-52, July.
- Merton, Robert C., 1977. "On the cost of deposit insurance when there are surveillance costs," Working papers 903-77., Massachusetts Institute of Technology (MIT), Sloan School of Management.
- Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July.
- Goetz von Peter, 2004. "Asset Prices and Banking Distress: A Macroeconomic Approach," Finance 0411034, EconWPA.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Simon Chan).
If references are entirely missing, you can add them using this form.