Integrating Solvency and Liquidity Stress Tests: The Use of Markov Regime-Switching Models

Abstract

The paper presents a framework to integrate liquidity and solvency stress tests. An empirical study based on European bond trading data finds that asset sales haircuts depend on the total amount of assets sold and general liquidity conditions in the market. To account for variations in market liquidity, the study uses Markov regime-switching models and links haircuts with market volatility and the amount of securities sold by banks. The framework is accompanied by a Matlab program and an Excel-based tool, which allow the calculations to be replicated for any type of traded security and to be used for liquidity and solvency stress testing.

Keywords: Financial markets, Financial institutions, Financial crises, Financial instruments, Macroprudential policies and financial stability, stress testing, solvency risk, liquidity risk, asset fire sales, Markov regime-switching models, WP, market liquidity, fire sale, fire-sale, haircut, asset class

JEL Classification: G12, G21, G32, E01, F16, E63