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Aliquidity Risk Stress-Testing Framework With Interaction Between Market And Credit Risks

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Executive Summary

This paper develops a stress-testing framework to assess liquidity risk of banks, where liquidity and default risks can stem from the crystallisation of market risk arising from a prolonged period of negative asset price shocks. In the framework, exogenous asset price shocks increase banks' liquidity risk through three channels. First, severe mark-to-market losses on the banks' assets increase banks' default risk and thus induce significant deposits outflows. Secondly, the ability to generate liquidity from asset sales continues to evaporate due to the shocks. Thirdly, banks are exposed to contingent liquidity risk, as the likelihood of drawdown's on their irrevocable commitments increases in such stressful financial environments.

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