Integrated Stress Testing: Impact on Liquidity and Solvency

Abstract

The global financial crisis has reminded us that effective stress tests should not only be probabilistic, but also consider risk interdependence. In this paper, we combine two hypothetical shocks, of varying degrees, with more than fifteen years of fortnightly data on deposits, borrowings and assets for the Indian banking sector. Our objective is to estimate the impact of stressed outflows on liquidity and solvency positions. We find that large shocks worsen existing short-term liquidity deficits. Moreover, the associated fall in book value of assets is more than the aggregate Common Equity Tier 1 Capital.

Keywords: Liquidity Risk, simulation models, Risk interactions, Capital adequacy

JEL Classification: C60, G13, G28