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December 2014 issue
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Introducing Funding Liquidity Risk in a Macro Stress-Testing Framework

by Céline Gauthiera, Moez Souissib and Xuezhi Liuc

Abstract

The main contribution of this paper is to introduce a funding liquidity component `a la Morris and Shin (2009) in a stresstesting framework. As a result, funding liquidity risk arises as an endogenous outcome of the interactions between market liquidity and solvency risks, and banks’ liquidity profiles. We perform a calibration exercise that highlights the vulnerability of leveraged institutions to the combination of low cash holdings and the prevalence of short-term debt, a key feature of the 2008 credit crisis. We also analyze the trade-offs between higher capital ratios, more liquid assets, and/or less short-term liabilities in reducing systemic risk.

JEL Codes: G01, G21, G28, C72, E58.

 
Full article (PDF, 37 pages, 1267 kb)


a Bank of Canada
b International Monetary Fund
c Manulife Financial