Measuring the stability of the banking system: capital and liquidity at risk with solvency-liquidity interactions

Giovanni Covi and Tihana Škrinjarić
Additional contact information
Giovanni Covi: Bank of England

No 1140, Bank of England Staff Working Paper series from Bank of England

Abstract: This study develops a stochastic balance sheet based microstructural banking model to quantify the dynamic interplay between solvency and liquidity risks – two traditionally distinct dimensions in stress testing. By incorporating endogenous bank reactions, feedback loops, and amplification mechanisms, the model captures how management responses to shocks can escalate financial distress, potentially leading to insolvency and illiquidity. We apply the model to granular loan and security exposure data from UK banks over 2015–24, estimating capital and liquidity at risk and deriving a systemic default probability indicator. Results indicate an average one-year bank default probability of 0.7%, consistent with market-implied estimates but diverging during stress episodes. Amplification effects, driven by balance sheet constraints and behavioural responses, account for approximately one third of default risk on average. Counterfactual analyses further evaluate the effectiveness of capital requirements and identify optimal capital levels under hypothetical stress scenarios.

Keywords: Banking stability; solvency-liquidity interactions; financial contagion; macroprudential stress test (search for similar items in EconPapers)
JEL-codes: D85 G21 G32 L14 (search for similar items in EconPapers)
Pages: 61
Date: 2025-08-29
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.bankofengland.co.uk/-/media/boe/files/ ... e-banking-system.pdf

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:023262

Access Statistics for this paper

More papers in Bank of England Staff Working Paper series from Bank of England Bank of England, Threadneedle Street, London, EC2R 8AH. Contact information at EDIRC.
Bibliographic data for series maintained by Research ().