Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information
IMF Working Papers, November 1, 2011
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Bibliographic details
- Authors: Liliana B Schumacher, Theodore M. Barnhill
- Published: November 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781463924614.001
Summary findings
- 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.
- Estimates the probability that multiple banks will fail or experience liquidity runs simultaneously.
- Significant systemic risk factors identified:
- 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,
- inadequate capital.
- 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 (no further numeric detail provided on the page).
- Increases in equity capital levels needed to reduce bank solvency and liquidity risk levels to a target confidence level are estimated to range from 3 percent to 20 percent of assets.
- For a future environment that replicates the 1987-2006 volatilities and correlations, the paper finds 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 the paper finds substantially elevated solvency and liquidity risks for all banks and the banking system.
Methodology
- Uses a forward looking simulation framework applying many risk factors to detailed bank balance sheets for a 10 bank stylized U.S. banking system.
- Analyzes correlated market and credit risk, correlated defaults of borrowers, other market risks, and inter-bank defaults to drive systemic banking system solvency risk.
- Models liquidity runs as endogenous responses by bank creditors to elevated solvency risk and to uncertainties about solvency, producing increased correlated failures.
Key quantitative results and scenarios
- Banking system modeled: 10 bank stylized United States banking system.
- Equity capital increases to achieve target risk confidence: range from 3 percent to 20 percent of assets.
- Historical environment calibrations discussed:
- 1987-2006 volatilities and correlations scenario: small risk of U.S. bank failures concentrated in thinly capitalized and regionally concentrated smaller banks.
- 2007-2010 financial environment calibration: substantially elevated solvency and liquidity risks for all banks and the banking system.
- Publication specifics on the page: Pages: 49; Issue: 263; Series: Working Paper No. 2011/263; Volume: 2011; DOI: https://doi.org/10.5089/9781463924614.001; ISBN: 9781463924614; ISSN: 1018-5941.
Drivers of systemic solvency and liquidity risk (as identified)
- Correlated defaults of many borrowers.
- Other market risks affecting asset values.
- Inter-bank defaults and contagion.
- Regime shifts to stressful financial and economic conditions.
- Poor initial loan credit quality.
- Loan portfolio sector and regional concentrations.
- Creditor behavior: sensitivity to solvency risk and uncertainties that drive runs.
- Inadequate equity capital buffers.
Policy implications and recommendations
- Strengthen equity capital buffers: estimated increases ranging from 3 percent to 20 percent of assets may be required to reduce solvency and liquidity risks to a target confidence level.
- Monitor and mitigate concentration risks in loan portfolios by sector and region to reduce correlated borrower defaults.
- Enhance supervision of loan credit quality and forward-looking stress testing under alternative environment calibrations (e.g., pre-2007 and 2007-2010 volatilities and correlations).
- Incorporate creditor behavior and uncertainty-driven liquidity runs into systemic risk assessment and contingency planning.
- Account for inter-bank exposures and potential contagion channels in systemic solvency and liquidity stress scenarios.
Modeling Correlated Systemic Liquidity and Solvency Risks in a Financial Environment with Incomplete Information — Miss Liliana B Schumacher, Theodore M. Barnhill (IMF Working Paper 2011/263).