Liquidity at Risk: Joint Stress Testing of Solvency and Liquidity

40 Pages Posted: 23 Jul 2020

See all articles by Rama Cont

Rama Cont

University of Oxford

Artur Kotlicki

University of Oxford - Mathematical Institute

Laura Valderrama

International Monetary Fund (IMF)

Multiple version iconThere are 2 versions of this paper

Date Written: June 1, 2020

Abstract

The traditional approach to the stress testing of financial institutions focuses on capital adequacy and solvency. Liquidity stress tests have been applied in parallel to and independently from solvency stress tests, based on scenarios which may not be consistent with those used in solvency stress tests. We propose a structural framework for the joint stress testing of solvency and liquidity: our approach exploits the mechanisms underlying the solvency-liquidity nexus to derive relations between solvency shocks and liquidity shocks. These relations are then used to model liquidity and solvency risk in a coherent framework, involving external shocks to solvency and endogenous liquidity shocks arising from these solvency shocks. We define the concept of ‘Liquidity at Risk', which quantifies the liquidity resources required for a financial institution facing a stress scenario. Finally, we show that the interaction of liquidity and solvency may lead to the amplification of equity losses due to funding costs which arise from liquidity needs. The approach described in this study provides in particular 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 and may serve as a useful tool for calibrating policy responses.

JEL Classification: C63, G21, G32, E01, K2, M41, E5

Suggested Citation

Cont, Rama and Kotlicki, Artur and Valderrama, Laura, Liquidity at Risk: Joint Stress Testing of Solvency and Liquidity (June 1, 2020). IMF Working Paper No. 20/82, Available at SSRN: https://ssrn.com/abstract=3652501

Rama Cont (Contact Author)

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://https://www.maths.ox.ac.uk/people/rama.cont

Artur Kotlicki

University of Oxford - Mathematical Institute ( email )

Andrew Wiles Building
Radcliffe Observatory Quarter (550)
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://https://www.maths.ox.ac.uk/people/artur.kotlicki

Laura Valderrama

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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