A view from the top: The interaction between solvency and liquidity stress

Abstract

In the context of stress testing, the interaction between solvency and liquidity stress has received too little attention in academic research as well as in practical application. This paper develops a number of interaction channels from solvency to liquidity and from liquidity to solvency. Thereby it draws on supervisory experience, case studies and the available theoretical literature. It then presents a conceptual framework to quantify the interaction by extending the Austrian central bank's framework for solvency and liquidity stress testing. In an empirical example based on the Austrian banking system the paper investigates the relative materiality of these channels. It uncovers two important trade-offs, one between quantitative impact of channels and the respective model risk/parameter uncertainty and another between conceptual quality and actionable output. The paper concludes that the importance of interaction between solvency and liquidity is too high to simply ignore and suggests approaches to model and to address the aforementioned trade-offs.