A1003
Title: A stress testing framework with interactions between solvency and liquidity risks and macro-financial linkages
Authors: Cho-hoi Hui - Hong Kong Monetary Authority (Hong Kong)
Tak Chuen Wong - Hong Kong Monetary Authority (Hong Kong) [presenting]
Kelvin Ho - Hong Kong Monetary Authority (Hong Kong)
Edward Tan - Hong Kong Monetary Authority (Hong Kong)
Abstract: A macro-stress testing framework is developed that incorporates interactions between solvency risk, funding and market liquidity risks, and macro-financial linkages. Specifically, the framework simulates macroeconomic shocks that increase solvency risk of banks, which in turn determines endogenously the timing and extent of deposit runs. Downward spirals between funding and market liquidity risks are incorporated in the framework, as in response to deposit outflows, banks are assumed to buffer the liquidity risk by selling financial assets. The resulting fall in prices of common assets held by banks (e.g. corporate debts) deteriorates the net worth of banks and thus exacerbating deposit outflows. For macro-financial linkages, the framework empirically relates the severity of macroeconomic shocks to the aggregate supply of bank credit, which in turn is jointly determined by the simulated solvency and liquidity conditions of banks. The framework is applied to the Hong Kong banking sector as an example. A counter-factual analysis is conducted to analyze how Basel III would improve banks resilience to such interactions of risks.
