Stress test struggle: separating liquidity and market risks

The financial crisis has been marked by episodes of extreme illiquidity, affecting everything from collateralised debt obligations to government bonds, but there has been little attempt to reflect these risks in stress tests. Some banks are building tests based on liquidation horizons – but more sophisticated, modelled approaches could be possible. Laurie Carver reports

Some inputs to a stress test are easy to understand and capture – a 15% fall in equity markets or an increase in interest rates, for example. Liquidity is not. While traders and investors have a feel for the relative liquidity of different markets, or periods of time, working out how to define a liquidity shock is less straightforward.

As a result, it has been relatively neglected, to the point