Liquidity stress tests for banks – range of practices and possible developments

Liquidity stress tests are traditionally employed by financial authorities to assess the materiality of liquidity risk within the banking sector. In a stress situation liquidity becomes concentrated in stronger firms: liquidity stress tests help the authorities to identify the weakest banks. They can also help to understand the propagation of the initial shock. This paper reviews a range of approaches used by authorities running liquidity stress tests and identifies three distinctive approaches. The first is liquidity stress testing exercises by individual banks. The second is stress testing exercises specifically designed with a sector-wide focus. Three such exercises are compared across several dimensions, including objectives, governance, scope, scenario design, methodology and supervisory follow-up. The third approach features exercises that help to assess interactions between banks and non-bank financial institutions (NBFIs).

In the light of liquidity events since 2020, the paper reviews the biggest challenges to liquidity stress tests, such as data issues and modelling capabilities, including the ability to model banks' management responses, interactions among banks and between banks and NBFIs, second-round effects and contagion risks. The paper also highlights key assumptions underpinning a stress test that may merit further refinement, such as those about price declines, liability outflow rates, the accounting treatment of high-quality liquid assets and exposure concentrations.

JEL classification: G21, G23, G28

Keywords: bank run, contagion, haircuts, NBFIs, outflow rates, scenario analysis