ECB tests banks’ sensitivity to liquidity risk

ECB tests banks’ sensitivity to liquidity risk

Although liquidity has been abundant in the euro area banking system in recent years, there have been a limited number of bank-specific liquidity crises. To test whether banks are ready to handle critical liquidity situations, the ECB has included the testing of banks’ resilience to liquidity shocks as one of the SSM supervisory priorities for 2019 and recently launched a sensitivity analysis of liquidity risk.

Press Release: ECB Banking Supervision conducts sensitivity analysis of liquidity risk as its 2019 stress test

The sensitivity analysis, which constitutes the supervisory stress test for 2019, involves about 100 significant institutions directly supervised by the ECB. In the exercise, banks have to simulate the impact of idiosyncratic liquidity shocks on their expected cash flows over a six-month stress horizon. These shocks are identical for stronger and weaker banks and disregard any differences related to the economic environment in which they operate. Similarly, there is no market-wide scenario or shock affecting asset prices, and the exercise is carried out without any reference to monetary policy decisions. This focused approach is similar to the one adopted for the 2017 sensitivity analysis of interest rate risk in the banking book (IRRBB), when the ECB tested banks’ exposure to hypothetical interest rate shocks. In the same way, the 2019 exercise does not specify the potential causes leading to a liquidity shock and focuses instead on the impact for banks.

The exercise compares banks’ expected short-term cash flows under stress against available unencumbered collateral. This enables supervisors to calculate their “survival period” – the number of days that the available cash and collateral can buy for a bank with no access to funding.

Banks are asked to simulate the impact of (i) an adverse shock and (ii) an extreme shock, in which they face liquidity outflows of increasing intensity. Shocks have been calibrated based on three key supervisory lessons learnt from recent crisis episodes. First, periods of liquidity stress may last longer than one month, the time horizon commonly used in short-term liquidity risk assessments. Second, deposit outflows under stress can be material and prolonged. And third, as banks find it hard to rein in new lending in response to a liquidity shock, the availability of unencumbered and readily available collateral is key. Banks are also asked to submit their benchmark expected cash flows under a “baseline” case, in which they honour all their contractual commitments with wholesale counterparties and experience no liquidity inflows or outflows from traditional lending and deposit-taking activities.

The exercise also focuses on the following aspects of liquidity risk management:

  • intragroup liquidity flows, including impediments to the flow of collateral between the euro area component of a group and its non-euro area subsidiaries
  • liquidity flows by currency, so as to isolate any liquidity mismatch in the relevant currencies
  • the ability of banks to mobilise collateral from existing assets

The exercise draws on existing supervisory reporting frameworks in order to ensure that banks’ resources are used efficiently. Data reported by banks will be challenged by a central team of supervisors by means of a dedicated quality assurance process. The team will draw on the bank-specific knowledge of existing Joint Supervisory Teams (JSTs). Quality assurance activities will focus on data quality and peer benchmarking to ensure a level playing field. Interactions with banks will continue until May/June 2019.

The results of the exercise will feed into European banking supervision’s ongoing assessments of banks’ liquidity risk management frameworks, including the Supervisory Review and Evaluation Process (SREP). However, the outcome of the stress test will not affect supervisory capital and liquidity requirements in a mechanical way. In fact, there will be no direct impact on capital requirements, as this would not be an appropriate way to address liquidity risks. Instead, the outcomes may lead to additional liquidity requirements and to supervisory requests to strengthen specific maturity buckets in order to improve the overall resilience of individual banks. Bank-specific results will be discussed bilaterally in the context of the SREP supervisory dialogues between supervisors and banks.

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