A comprehensive stress testing model to evaluate systemic contagion and market illiquidity in banks

Abstract

This dissertation presents a liquidity stress-testing model for evaluating liquidity and systemic risk in banks from developed and emerging economies respectively. The model further relies on simulations to generate liquidity buffer losses for both a non-crisis and crisis period as well. The emerging economy is represented by South Africa (SA) and the developed economy by the United Kingdom (henceforth UK). The Liquidity Stress Tester model (LST) has been successfully applied to both the Dutch and UK markets in previous research. The model's flexibility and adaptability allows it to assess different banking systems and different reactions (buffer restoration and leverage targeting) of participants within these milieus. The LST considers feedback effects arising from bank reactions and allows for the assessment of severely stressed haircuts and systemic risk increases caused by reputation degradation and increased contagion from other banks. Losses stemming from the second round effects of a liquidity event are explored through the reactions conducted by banks in the banking system. The study conducts a review of liquidity risk models utilised in previous research. Characteristics of these models and the data they used are highlighted, shedding light on the advantages and shortcomings of these models. Possible restrictions in liquidity risk management are also explored. The study discusses the relevance of the South African/UK economies' comparison, as well as the selected periods chosen for investigation. To assist further research with the LST, the study illustrates and discusses how it is modelled and developed in Microsoft Office Excel. The results obtained illustrate the potential severity of second round feedback effects of a liquidity event on liquidity positions in banks. The effects of mitigating actions conducted by banking institutions reacting to initial liquidity stress shocks are explored, as well as the way these actions could potentially affect second round effects on banks. The analysis and discussion of simulated results attempts to isolate and identify characteristics of economies and periods used that may have contributed to specific liquidity events. The study concludes with a summary of the research and suggestions for possible future work and development using the LST.