The Liquidity Risk Management Guide: From Policy to Pitfalls

10 Step V: Stress Testing and the Contingency Funding Plan

In the penultimate step of the ‘6 Step Framework’, the framework has moved beyond the stages of defining and measuring and is now set to produce more detailed results and guidance of the management of liquidity.

If someone is asked to name the reason for doing liquidity management, they would most likely answer that it is the necessity to be able to conduct liquidity stress testing and have a rescue plan ready should a liquidity storm break out. This chapter is focused solely on these two concepts but as everything else in the latter parts of the ‘6 Step Framework’, it draws upon results and findings from the earlier steps. If the groundwork has been properly constructed and the base built on sound assumptions, then the stress testing and contingency funding planning should not be a giant leap into the unknown.

10.1 STRESS TESTING – THE HEART OF THE LIQUIDITY FRAMEWORK

Stress testing is undoubtedly one of the cornerstones of a liquidity management framework and probably the most tangible part it deals with. It is also the part of the regime that needs the most maintenance as assumptions and risk levels change constantly. Due to the uncertain nature of liquidity risk, stress testing is vital to be able to quantify what the bank is up against. For the same reasons, the stress methodology and assumptions need to be regularly challenged for their relevance. For many other risk types, banks have built a generally accepted ...