Liquidity at Risk: Joint Stress Testing of Solvency and Liquidity
IMF Working Papers, June 5, 2020
Source details
- Canonical URL
- Liquidity at Risk: Joint Stress Testing of Solvency and Liquidity
Other formats
Bibliographic details
- Authors: Dalya Elmalt, Yiruo Li, Laura Valderrama
- Published: June 5, 2020
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513546131.001
Framework and methods
- Proposes a structural framework for the joint stress testing of solvency and liquidity that "exploits the mechanisms underlying the solvency-liquidity nexus to derive relations between solvency shocks and liquidity shocks."
- Models liquidity and solvency risk in a coherent framework involving:
- external shocks to solvency, and
- endogenous liquidity shocks arising from these solvency shocks.
- Uses the derived relations to ensure scenario consistency between solvency and liquidity stress tests rather than applying them in parallel and independently.
Definition and metrics
- Defines the concept of "Liquidity at Risk", which "quantifies the liquidity resources required for a financial institution facing a stress scenario."
Key findings and dynamics
- Shows that the interaction of liquidity and solvency can lead to amplification of equity losses due to funding costs which arise from liquidity needs.
- Highlights that traditional stress-testing approaches focusing on capital adequacy and solvency, while treating liquidity stress tests independently, can miss important risk interactions captured by the joint framework.
- Emphasizes the role of endogenous liquidity shocks that are triggered by solvency shocks in magnifying financial distress.
Policy implications and applications
- Provides "a clear methodology for quantifying the impact of economic shocks resulting from the ongoing COVID-19 crisis on the solvency and liquidity of financial institutions."
- Can serve as "a useful tool for calibrating policy responses" by quantifying required liquidity resources and identifying channels of loss amplification through funding-cost dynamics.
Subjects and keywords (as stated)
- Subjects: Asset and liability management; Financial regulation and supervision; Financial sector policy and analysis; Financial statements; Liquidity; Liquidity risk; Public financial management (PFM); Solvency; Stress testing.
- Keywords: amount; balance sheet; Financial statements; Global; interactions channels; Liquidity; liquidity risk; liquidity-solvency nexus; loss amplification; risk interaction; Solvency; solvency risk; solvency shock; solvency-liquidity diagram; solvency-liquidity nexus; stress scenario; stress testing; variation margin; WP.
Source: Dalya Elmalt, Yiruo Li, and Laura Valderrama, "Liquidity at Risk: Joint Stress Testing of Solvency and Liquidity", IMF Working Papers, June 5, 2020.
Content in this bundle
- Working Paper