Of Runes and Sagas: Perspectives on Liquidity Stress Testing Using an Iceland Example

IMF Working Papers, July 1, 2010

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Canonical URL: Of Runes and Sagas: Perspectives on Liquidity Stress Testing Using an Iceland Example

The global financial crisis revealed weaknesses in stress testing exercises performed on financial institutions and systems, particularly in the area of liquidity risk.
The paper uses publicly available data from a now-defunct bank in Iceland, where liquidity shocks were immense, to demonstrate how combined stress tests of various risks would have provided a clearer picture of existing vulnerabilities.
The authors argue that stress test models do not need to be complex or overly sophisticated; basic stress tests with appropriate assumptions and shocks can reveal key risk areas to inform contingency planning.
The liquidity stress test templates used in the paper are included.

Stress tests prior to the crisis largely focused on solvency risk and left liquidity vulnerabilities largely undetected.
A combination of stress tests covering various risks would have provided a clearer picture of vulnerabilities in the Icelandic bank example.
Basic stress testing approaches, when using appropriate assumptions and shocks, can identify critical areas for contingency planning without requiring highly complex models.

Analysis relies on publicly available data from a now-defunct Icelandic bank (Landsbanki Íslands referenced in keywords).
Liquidity stress test templates used in the paper are included with the publication.

Implement combined stress testing frameworks that explicitly include liquidity risk alongside solvency assessments.
Use appropriate assumptions and shocks in basic stress testing models to identify key vulnerabilities and inform contingency planning.
Ensure stress testing exercises are sufficiently broad to detect liquidity shocks similar to those experienced by the Icelandic bank examined.