Liquidity Stress Testing a Tool for Integrated Liquidity Risk Management

Abstract

Stress Test is forward looking simulation exercise to assess resilience of financial institutions in the midst of sever but plausible adverse scenario.Liquidity Stress testing is an important means for sketching out acomprehensive picture of liquidity risk profile of an institution. Stress testing is a powerful tool in the hands of Liquidty risk managers.Liquidity stress testing involves weighing potential net liquidity outflow exposures under stressed scenarios vis a vis the available counterbalancing capacity. Varying behaviour of fund providers and users in different stress situations based on their market and solvency perception of the concerned institutions necessitates measurement and management of liquidity risk scenario specific. Identification of cash-flow drivers is perhaps the most crucial step in defining and structuring the scenario parameters. Deterministic stress test pivots on assumptions and methods. The set of assumptions have to be as realistic as possible ensuring proper alignment in an internally consistent way. The stress test outcomes help in identification of severe vulnerabilities. The method however involves subjectivity throwing ideas about loss severity without any estimate of associated chance and probability of occurrence thereof. Stress Tests based on hypothetical data and assumptions are useful but not accurate. Stress testing provides where withal for formulation of the plan to tackle effectively liquidity problems as when arising. Stress testing work as effective tool provided its outcomes and findings are properly evaluated and incorporated in the strategic plan. Stress testing is not the ultimate! Instead it forms only a component of dynamic and integrated liquidity risk management process. However, stress testing is definitely an effective tool providing valuable inputs to risk management decisions provided it is sufficiently embedded and aligned to risk management frameworks and senior management decision making frameworks.