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White Paper

A Stress Testing Framework for Liquidity Risk

 

Regulators have mandated liquidity risk stress testing for banks in addition to the market risk and credit risk stress testing. Banks must come up with a framework and processes for liquidity risk stress testing. 

One of the most important lessons learned from the recent financial crisis is that liquidity risk is fundamentally different from other forms of risk such as market and credit risk. Liquidity risk, viewed earlier as a second-order risk, is now considered a major risk class. The crisis showed us how quickly a risk, which starts as a market or credit risk, transforms into a liquidity event and how rapidly it develops into a systemic issue. The drying out of liquidity from the market results in the collapse of traditionally strong institutions.

Since liquidity risk is a key risk class, it needs its own risk measures such as Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR) as prescribed by the Basel Committee on Banking Supervision (BCBS). It should also have some common measures that banks across the globe use such as gap ratios based on structural and tactical liquidity, concentration metrics and others. Since liquidity risk measures are unique, it would be logical to create a stress testing framework designed to suit the needs of liquidity risk.

The current economic environment is one wherein uncertainty and volatility have become the new normal. Financial institutions have to devise techniques to continually understand and analyze the factors that affect their business and develop strategies to ensure business-as-usual when thing go wrong.

A well-designed Stress Testing Framework provides the ability to design forward-looking extreme, yet plausible scenarios and strategies to counter the effects of an extreme event. In this white paper, we propose a Stress Testing Framework designed to handle liquidity risk.