A liquidity risk stress-testing framework with interaction between market and credit risks

A liquidity risk stress-testing framework with interaction between market and credit risks Eric Wong* and Cho-Hoi Hui* This version: April 11, 2011 Abstract This study develops a framework for stress testing banks’ liquidity risk, where liquidity and default risks can stem from market risk arising from asset price shocks. The risks are assumed to be transmitted through three channels. First, banks’ mark-to-market losses on assets increase their default risk and thus induce deposit outflows. Second, asset price declines reduce banks’ asset liquidity. Third, banks also face higher contingent liquidity risk, as the likelihood of drawdowns on irrevocable commitments by customers increases in the stress scenario. Contagion risk is also incorporated in the framework through banks’ linkages in the interbank and capital markets. The framework quantifies liquidity risk by estimating the expected cash shortage time and the expected default time of banks. Stress testing results from this framework suggest that liquidity risk in the Hong Kong banking sector would be contained even if such stress scenario were to occur.