Liquidity stress testing with second-round effects: application to the Czech banking sector

Abstract

We build a macro stress-testing model for banks’ market and funding liquidity risks with a survival period of one month. The model takes into account the impact of both bank-specific and market-wide scenarios and includes second-round effects of shocks due to banks’ feedback reactions. The model has three phases: (i) the formation of a balance-sheet liquidity shortfall, (ii) the reaction of banks on financial markets, and (iii) the feedback effects of shocks, such as secondary deposit outflows for reacting banks and additional haircuts on securities. During each phase, we recount the liquidity buffer and examine whether banks hold a sufficiently large amount of liquid assets to be able to survive the liquidity tension in their balance sheets. The framework is applied to the Czech banking sector to illustrate typical calibrations and the impact on banks.