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Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information

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  • Liliana B Schumacher
  • Theodore M. Barnhill

Abstract

This paper proposes and demonstrates a methodology for modeling correlated systemic solvency and liquidity risks for a banking system. Using a forward looking simulation of many risk factors applied to detailed balance sheets for a 10 bank stylized United States banking system, we analyze correlated market and credit risk and estimate the probability that multiple banks will fail or experience liquidity runs simultaneously. Significant systemic risk factors are shown to include financial and economic environment regime shifts to stressful conditions, poor initial loan credit quality, loan portfolio sector and regional concentrations, bank creditors' sensitivity to and uncertainties regarding solvency risk, and inadequate capital. Systemic banking system solvency risk is driven by the correlated defaults of many borrowers, other market risks, and inter-bank defaults. Liquidity runs are modeled as a response to elevated solvency risk and uncertainties and are shown to increase correlated bank failures. Potential bank funding outflows and contractions in lending with significant real economic impacts are estimated. Increases in equity capital levels needed to reduce bank solvency and liquidity risk levels to a target confidence level are also estimated to range from 3 percent to 20 percent of assets. For a future environment that replicates the 1987-2006 volatilities and correlations, we find only a small risk of U.S. bank failures focused on thinly capitalized and regionally concentrated smaller banks. For the 2007-2010 financial environment calibration we find substantially elevated solvency and liquidity risks for all banks and the banking system.

Suggested Citation

  • Liliana B Schumacher & Theodore M. Barnhill, 2011. "Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information," IMF Working Papers 11/263, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:11/263
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Rodolfo Maino & Kalin I Tintchev, 2012. "From Stress to Costress; Stress Testing Interconnected Banking Systems," IMF Working Papers 12/53, International Monetary Fund.
    2. International Monetary Fund, 2013. "European Union; Publication of Financial Sector Assessment Program Documentation—Technical Note on Stress Testing of Banks," IMF Staff Country Reports 13/68, International Monetary Fund.
    3. de Haan, Leo & van den End, Jan Willem, 2013. "Bank liquidity, the maturity ladder, and regulation," Journal of Banking & Finance, Elsevier, vol. 37(10), pages 3930-3950.
    4. Souza, Sergio Rubens Stancato de, 2016. "Capital requirements, liquidity and financial stability: The case of Brazil," Journal of Financial Stability, Elsevier, vol. 25(C), pages 179-192.
    5. Borio, Claudio & Drehmann, Mathias & Tsatsaronis, Kostas, 2014. "Stress-testing macro stress testing: Does it live up to expectations?," Journal of Financial Stability, Elsevier, vol. 12(C), pages 3-15.
    6. Kalin I Tintchev, 2013. "Connected to Whom? International Interbank Borrowing During the Global Crisis," IMF Working Papers 13/14, International Monetary Fund.
    7. Manning, Matthew, 2016. "Markets and operations: 2016 Q3," Bank of England Quarterly Bulletin, Bank of England, vol. 56(3), pages 146-154.
    8. repec:vrs:demode:v:4:y:2016:i:1:p:26:n:15 is not listed on IDEAS
    9. Dent, Kieran & Westwood, Ben & Segoviano, Miguel, 2016. "Stress testing of banks: an introduction," Bank of England Quarterly Bulletin, Bank of England, vol. 56(3), pages 130-143.
    10. Hsu, S. & Li, J. & Qin, Y., 2013. "Shadow Banking and Systemic Risk in Europe and China," CITYPERC Working Paper Series 2013-02, Department of International Politics, City University London.
    11. Sergio R. Stancato de Souza, 2014. "Capital Requirements, Liquidity and Financial Stability: the case of Brazil," Working Papers Series 375, Central Bank of Brazil, Research Department.

    More about this item

    Keywords

    Stress tests; Solvency risk; systemic liquidity; probability; banking; banking system; bank failures; probabilities; General Financial Markets: Other;

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