Stress-Testing Liquidity Risks in the New Regulatory Environment

Liquidity crises negatively impact functioning of financial markets and economic activity. The financial crisis of 2007-8 spread fast across institutions and markets, caused the change in the view of managing liquidity risks. The uncertainty about counterparty risk and future funding needs made maintaining of market access dffficult. The funding costs increased Regulatory authorities responded with an abundance of tighter requirements to strengthen risk management practices and stability of the banking system. In context of the new regulatory requirements (Basel HI, ERA) for liquidity stress-testing the present paper address some straits small to middle sized banks have to deal with. It also presents a stochastic stress-test model where multiple dimensions of liquidity risk are combined Hypothetical costs a bank should expect for liquidity provision in a particular point of time when future financing conditions worsen can be quantified. A realistic risk i.e. costs after exhaustion of the compensation capacity, is measured by Value at Risk and Expected Shortfall.