A liquidity risk stresstesting framework with interaction between Market and Credit Risk.docx

A liquidity risk stresstesting framework with interaction between Market and Credit Risk.docx

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AliquidityriskstresstestingframeworkwithinteractionbetweenMarketandCreditRisk

1

Aliquidityriskstress-testingframeworkwithinteractionbetween

marketandcreditrisks

EricWong*+

andCho-HoiHui*

Thisversion:

April11,2011

Abstract

Thisstudydevelopsaframeworkforstresstestingbanks’liquidityrisk,where

liquidityanddefaultriskscanstemfrommarketriskarisingfromassetpriceshocks.

Therisksareassumedtobetransmittedthroughthreechannels.First,banks’

mark-to-marketlossesonassetsincreasetheirdefaultriskandthusinducedeposit

outflows.Second,assetpricedeclinesreducebanks’assetliquidity.Third,banksalso

facehighercontingentliquidityrisk,asthelikelihoodofdrawdownsonirrevocable

commitmentsbycustomersincreasesinthestressscenario.Contagionriskisalso

incorporatedintheframeworkthroughbanks’linkagesintheinterbankandcapital

markets.Theframeworkquantifiesliquidityriskbyestimatingtheexpectedcash

shortagetimeandtheexpecteddefaulttimeofbanks.Stresstestingresultsfromthis

frameworksuggestthatliquidityriskintheHongKongbankingsectorwouldbe

containedevenifsuchstressscenarioweretooccur.

JELclassifications:

C60,G21,G28

Keywords:

Liquidityrisk,stresstesting,defaultrisk,marketrisk,banks,HongKong

*ResearchDepartment,HongKongMonetaryAuthority,55/F,TwoInternationalFinanceCentre,8,

FinanceStreet,Central,HongKong,China.Email:

etcwong@hkma.gov.hk,andchhui@hkma.gov.hk

Phone:

（852）28788735Fax:

（852）28781891

+Correspondence.

TheauthorswouldliketothankNaohikoBaba,KlausDuellmann,HansGenberg,MartinGrieder,

participantsatthethirdannualworkshopoftheAsianResearchNetworkson25March2010

co-organisedbytheBankforInternationalSettlementsandBankofJapan;theresearchworkshop

“ChallengesinBankingResearch”on28-29May2009organisedbytheResearchTaskForceofthe

BaselCommitteeonBankingSupervisionandsponsoredtheBankofSpain,and“theThirdStress

TestingExpertForum:

AdvancedTechniquesinStressTesting”on19-20May2009organisedbythe

IMFandDeutscheBundesbankfortheirusefulsuggestionsandcomments.Theviewsandanalysis

expressedinthepaperarethoseoftheauthors,anddonotnecessarilyrepresenttheviewsoftheHong

KongMonetaryAuthority.1

1.Introduction

AsillustratedbyrecentdevelopmentsintheUSandEuropean

bankingsystems,liquidityanddefaultrisksofbankscanstemfromthecrystallisation

ofmarketriskandsuchinteractionofriskscouldleadtosystemiccrises,e.g.the

sub-primecrisisemergedin2007.1

Whilethebankingsystemsinmostother

economieshaveshownrelativelyresilient,theyarenotimmunetosimilarcrises

becauseofthreecommonfeaturesrunningthroughallbankingsystems.First,banks’

balancesheetsareinevitablyexposedtocommonmarketriskfactors,asthey

generallyholdsimilarfinancialassets.Thus,significantassetpricedeclines,even

onlyinasinglemarket,couldexposealargenumberofbankstosubstantialmarket

risklosses.Secondly,thecapitalavailableforbankstobufferagainstsuchmarket

risklossesislimited,asbanksusuallyoperatewithahighleveloffinancialleverage.

Thissuggeststhatallbankingsystemsareessentiallyvulnerabletomultipledefault

riskduringseveremarketriskshocks.Thirdly,interbankmarketsareextremely

sensitivetodefaultrisk.Anyshockthatincreasesthedefaultriskofbankscould

resultintightenedinterbankmarkets,creatingsystemicliquidityshortages.

Forbankingstabilityitis,therefore,importanttoassesstheextenttowhich

abankingsystemisexposedtosuchaninteractionofrisks.However,intheliterature,

stress-testingframeworkscapturingtheinteractionofrisksarerelativelyscant.Tofill

thisgap,thisstudydevelopsanewstress-testingframeworktoassesstheliquidity

1

Thedevelopmentofthesub-primecrisiscanbesummarisedasfollows:

Intheearlystage（around

thesecondhalfof2007）,therewerecontinualannouncementsofsignificantmark-to-market

write-downsofsub-primemortgage-relatedsecuritiesbyfinancialinstitutionsintheUSandEuropeas

aresultofdeteriorationintheassetqualityofsub-primemortgages.Suchcrystallisationofmarketrisk

triggeredconcernsofbanks’defaultriskquickly,asevidencedbyincreasesincreditdefaultswap

spreadsofbankssincethethirdquarterof2007.Defaultriskofbankswasamplifiedfurtherfollowing

thedebacleofsomelargefinancialinstitutions,includingBearStearns,FreddieMacandFannieMae.

Asdefaultriskheightened,banksbecameincreasinglyreluctanttolendamongthemselves,resultingin

thesystemicliquidityproblemsintheglobalinterbankmarketsinmid-September2008followingthe

collapseofLehmanBrothers,despitetheunprecedentedactionsandmeasurestakenbeforebyvarious

centralbanksandgovernmentstoinjectliquidityintheglobalbankingsystem.2

riskofbanksinthiscontext.

Intheframework,weassumethatthereisaprolongedperiod（i.e.oneyear）

ofnegativeexogenousassetpriceshocksinsomemajorfinancialmarkets,which

affectbanks’liquidityriskthroughthreechannels:

（i）increasesinbanks’defaultrisk

anddepositoutflows;（ii）reductioninbanks’liquiditygenerationcapability;and（iii）

increasesincontingentdrawdowns.Defaultriskofbanksisendogenously

determinedusingaMerton-typemodelintheframework.2

Contagiousdefaultriskis

incorporatedthroughbanks’linkageoninterbankandcapitalmarketsthatis

consistentwiththetheoriesintheliterature.

Withthisframework,dailycashoutflowsofbankscanbesimulatedgiven

exogenousassetpriceshocks.UsingtheMonteCarlomethod,theframework

quantifiestheliquidityriskofindividualbanksbyestimatingtheprobabilityofcash

shortageandtheprobabilityofdefaultduetoliquidityproblems.Inaddition,

conditionalonoccurrencesofcashshortageanddefaultinthesimulations,thefirst

cashshortagetimeandthedefaulttimecanbeestimatedrespectively.The

correspondingprobabilityofmultipledefaultsofbanksinabankingsystemcanbe

alsoestimated,whichisanimportantmeasureforassessingthesystemicriskinthe

bankingsystem.Theframeworkwithtwostressscenariosisappliedtoassessthe

liquidityriskofagroupof12listedbanksinHongKongwithpubliclyavailable

data.

Thisstudydrawsontheliteraturethatrelatestotheimpactofassetprice

2

UsingMerton-typemodelstoendogenisedefaultriskofbanksinsystemicriskassessment

frameworksisalsoadoptedbyAspachsetal.（2006）,whichisbasedonthetheoreticalframeworkby

Goodhartetal.（2006）.3

declinesonbanks’defaultrisk.Cifuentesetal.（2005）andAdrianandShin（2008a,

2008b）provideatheoreticalfoundationonhowasmallassetpriceshockcanbe

amplifiedbyitsmark-to-market（MTM）effectsonbanks’balancesheets,andthus

leadstoadownwardspiralinassetpricesandcontagiousdefaultsofbanksthrough

interbanklinkages.3

Theimportanceofthelinkagebetweenassetpricesanddefault

riskofbankshasrecentlybeenrecognisedandstudiedempiricallybyBossetal.

（2006）andAlessandrietal.（2007））.However,theimplicationsforbanks’liquidity

risk,whicharecrucialforpolicymarkersinviewofthesub-primecrisis,arenotthe

mainfocusofthesestudies.vandenEnd（2008）incorporatestheinteractionbetween

marketandfundingliquidityandpotentialfeedbackonbanksintoaframeworkto

assessliquidityriskofDutchbanksbyestimatingthedistributionsofliquiditybuffers

andprobabilityofliquidityshortfallofbanks.However,theeffectofmarketrisk

shocksondefaultriskofbanksandinturntheirdepositoutflows（andliquidityrisk）

arenotexplicitlymodelledintheframework.Bycontrast,theproposedframeworkin

thispapertriestoestablishthelinkagesbetweenliquidityrisk,marketriskandbanks’

defaultrisk.ItisalsorelatedtothetheoreticalframeworkbyDiamondandRajan

（2005）whichshowsthatanaggregateliquidityshortagecanbecausedbybankruns

perceivedbybankinsolvency.

Thisstudycontributestotheliteratureintwoaspects.First,thisisamong

fewempiricalstudiestoincorporateinteractionofrisksinaliquidityrisk

stress-testingframework.Giventhatthesub-primecrisisishighlyrelevanttosuch

interactionofrisks,theframeworkcouldbeusefulforpolicymakerstoassesshow

resilientabankingsectorisunderliquidityshockssimilartoorevensevererthan

3

SeealsoAllenandGale（1994,1998and2000a）,AcharyaandYorulmazer（2007）,andNieretal

（2007）.InadditiontotheMTMeffects,assetpricecollapsecouldcausebankfailuresbecauseof

widespreaddefaultsofbanks’lendingtoinvestorsforacquiringriskyassets（seeAllenandGale

（2000b）andGoetzVonPeter（2004））.4

thoseoccurredinthesub-primecrisis.Secondly,theframeworkcouldserveasa

complementarytooltothebottom-upapproachforliquidityriskstresstesting.Thisis

particularlysoinviewofthedifficultytoincorporatecontagiousdefaultriskunder

thebottom-upapproach.4

Bycontrast,defaultriskofbanksisendogenisedinthis

frameworkandcontagiousdefaultriskisthuspossiblethroughinterbankandcapital

markets.Theproposedframeworkcanbereadilyappliedtootherbankingsystemas

therequiredinputdataarepubliclyavailable.

Thereminderofthepaperisorganisedasfollows.Thestress-testing

frameworkisoutlinedinthefollowingsection.Sections