Integrating Solvency and Liquidity Stress Tests: The Use of Markov Regime-Switching Models

Fei Han and Mindaugas Leika

No 2019/250, IMF Working Papers from International Monetary Fund

Abstract: The paper presents a framework to integrate liquidity and solvency stress tests. An empirical study based on European bond trading data finds that asset sales haircuts depend on the total amount of assets sold and general liquidity conditions in the market. To account for variations in market liquidity, the study uses Markov regime-switching models and links haircuts with market volatility and the amount of securities sold by banks. The framework is accompanied by a Matlab program and an Excel-based tool, which allow the calculations to be replicated for any type of traded security and to be used for liquidity and solvency stress testing.

Keywords: WP; market liquidity; cash flow; funding shortage; optimization strategy; stress testing; solvency risk; liquidity risk; asset fire sales; Markov regime-switching models; asset class; low-liquidity regime; asset fire-sale model; market liquidity condition; liquidity shortage; fire-sale model; shock transmission mechanisms; market liquidity shock; liquidity spiral; liquidity constraint; liquidity gap; Liquidity; Asset liquidity; Asset management; Sovereign bonds; Global (search for similar items in EconPapers)
Pages: 41
Date: 2019-11-15
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