A Liquidity Risk Stress-Testing Framework with Interaction between Market and Credit Risks

33 Pages Posted: 1 Apr 2009 Last revised: 5 May 2009

See all articles by T. C. Wong

T. C. Wong

Hong Kong Monetary Authority - Research Department

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Date Written: March 27, 2009

Abstract

This study 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 drawdowns on their irrevocable commitments increases in such stressful financial environments. In the framework, the linkage between market and default risks of banks is implemented using a Merton-type model, while the linkage between default risk and deposit outflows is estimated econometrically. Contagion risk is also incorporated through banks' linkage in the interbank and capital markets. Using the Monte Carlo method, the framework quantifies liquidity risk of individual banks by estimating the expected cash-shortage time and the expected default time. Based on publicly available data as at the end of 2007, the framework is applied to a group of banks in Hong Kong. The simulation results suggest that liquidity risk of the banks would be contained in the face of a prolonged period of asset price shocks. However, some banks would be vulnerable when such shocks coincide with interest rate hikes due to monetary tightening. Such tightening is, however, relatively unlikely in a context of such shocks.

Keywords: Liquidity risk, stress testing, default risk, banks

JEL Classification: C60, G13, G28

Suggested Citation

Wong, Tak-Chuen and Hui, Cho-Hoi, A Liquidity Risk Stress-Testing Framework with Interaction between Market and Credit Risks (March 27, 2009). Available at SSRN: https://ssrn.com/abstract=1370826 or http://dx.doi.org/10.2139/ssrn.1370826

Tak-Chuen Wong (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

55/F, Two International Finance Centre,
8 Finance Street, Central,
Hong Kong
Hong Kong

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

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