IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this paper

A Liquidity Risk Stress-Testing Framework with Interaction between Market and Credit Risks

  • Eric Wong

    (Research Department, Hong Kong Monetary Authority)

  • Cho-Hoi Hui

    (Research Department, Hong Kong Monetary Authority)

Registered author(s):

    This 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.

    If 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.

    File URL:
    Download Restriction: no

    Paper provided by Hong Kong Monetary Authority in its series Working Papers with number 0906.

    in new window

    Length: 33 pages
    Date of creation: Mar 2009
    Date of revision:
    Handle: RePEc:hkg:wpaper:0906
    Contact details of provider: Postal:
    55th Floor, Two International Finance Centre, 8 Finance Street, Central

    Phone: (852)28788261
    Fax: (852)28781892
    Web page:

    More information through EDIRC

    References listed on IDEAS
    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.:

    as in new window
    1. 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.
    2. Adrian, T. & Shin, H S., 2008. "Liquidity and financial contagion," Financial Stability Review, Banque de France, issue 11, pages 1-7, February.
    3. 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.
    4. 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.
    5. 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.
    6. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
    7. Douglas W. Diamond & Raghuram G. Rajan, 2005. "Liquidity Shortages and Banking Crises," Journal of Finance, American Finance Association, vol. 60(2), pages 615-647, 04.
    8. Pierre Collin-Dufresne, 2001. "Do Credit Spreads Reflect Stationary Leverage Ratios?," Journal of Finance, American Finance Association, vol. 56(5), pages 1929-1957, October.
    9. 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.
    10. von Peter, Goetz, 2009. "Asset prices and banking distress: A macroeconomic approach," Journal of Financial Stability, Elsevier, vol. 5(3), pages 298-319, September.
    11. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008. "Network models and financial stability," Bank of England working papers 346, Bank of England.
    12. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and financial cycles," BIS Working Papers 256, Bank for International Settlements.
    13. Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005. "Liquidity risk and contagion," Bank of England working papers 264, Bank of England.
    14. 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, pages 83-95.
    15. Goetz von Peter, 2004. "Asset Prices and Banking Distress: A Macroeconomic Approach," Finance 0411034, EconWPA.
    16. 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.
    17. 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.
    18. 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.
    19. 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.
    20. 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.
    Full references (including those not matched with items on IDEAS)

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    When requesting a correction, please mention this item's handle: RePEc:hkg:wpaper:0906. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Simon Chan)

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.