Other Risks
Stress tests can be performed on other risks, including liquidity risk, commodity risk, or equity price risk. Asset liquidity risk refers to the inability to conduct a transaction at current market prices because of the size of the transaction. Funding liquidity risk refers to the inability to access sufficient funds to meet payment obligations in a timely manner. Liquidity risk can be assessed by imposing a “haircut” on the liquid assets of an institution and by examining the effect on the liquid assets ratio (for asset liquidity risk). A conservative scenario would be to assume that only the cash held by banks (in domestic and foreign currency), as well as the reserve requirements, were always liquid.
The next step would be to add to the category of liquid assets those deposits that banks hold abroad. Deposits with local banks can become illiquid if the country is con
fronted with a systemic liquidity crisis. Similarly, domestic government or corporate bonds can rapidly become illiquid when enough banks are trying to sell the assets all at once. Conversely, to the extent that the liquidity crisis does not affect the main financial centers, banks could dispose of their foreign bonds to meet liquidity outflows at home. For funding liquidity risk, a stress test can be constructed on the basis of assumptions about the ability of an institution to continue attracting sources of funds. For example, the rate of withdrawal of deposits or other funding sources can be increased, or assumptions can be made about the withdrawal of credit lines and other funding sources to determine the effect on some measure of liquidity for the institution.
Commodity risk refers to the potential losses that may result from changes in the market price of bank assets and liabilities, as well as off-balance-sheet instruments caused by commodity price changes. Even if financial institutions do not take positions in commodities or commodity-linked instruments directly, they may be subject to commodity price risk indirectly through the effect on their loan portfolio. This risk occurs if their borrowers’ ability to repay their debts is affected by shocks to commodity prices. This indirect source of commodity risk can be particularly important for many banks in developing countries that lend to exporters or to importers of commodities.
Commodity risk can be assessed by examining the effect of a fall in the value of the commodity (e. g., oil or copper) on the balance sheets of financial institutions. This assessment can be either through their direct holdings of the commodity or indirectly through an analysis of the effect on key customers. One can calculate the financial institution’s net position in the most-relevant commodities by netting long and short positions, which are expressed in terms of the standard unit of measurement, in the same commodity. The net position can then be converted into the national currency at current spot rates for the commodity. Commodity derivatives should be converted into notional commodities positions and can be included in the framework in the same way. Assuming a price fall of 20 percent, for example, and estimating the dollar value of this shock show the sensitivity of the portfolio to this commodity.
Equity price risk is the risk that stock price changes affect the value of an institution’s assets and liabilities and its off-balance-sheet items. Equity price risk consists of two components: specific equity price risk and general equity price risk. Specific equity price risk refers to the risk associated with movements in the price of an individual stock. General equity price risk is the risk associated with movements of the stock market as a whole. Similar to commodity price risk, the starting point for measuring sensitivity to equity price risk is to calculate the net open position, including on - and off-balance-sheet positions in each equity security, including equity derivatives, converted into notional equity positions (options are delta weighted).
If one is to stress test for specific market risk—that is, equity risk related to the individual issuer—the stress test would have to be applied to the net open position in the equity concerned. Such a stress test would primarily be relevant when the institution is known to hold a highly concentrated trading portfolio of equities. More commonly, stress tests are conducted for general market risk, that is, the risk related to a major change in the overall stock market, usually a market crash scenario. For this purpose, the net open positions of an institution in all equities would be aggregated, and the stress scenario would be applied to the institution’s aggregate position.
Financial institutions that include equity risk factors in their internal models should conduct comprehensive stress tests using their own measurement techniques and should provide the results to regulators. For those institutions, the net open positions in each equity should still be available, before aggregation into the overall position, and the model should be able to stress test each equity separately. Internal models can also be used to implement scenario analysis, thus taking account of correlations among stock prices, or indices, although those correlations may break down during crises.
Equity exposures in the trading book may be subject to frequent and substantial swings, along with stock market developments. The results of stress tests can, therefore, be outdated fairly quickly. Whereas supervisory reports or published annual reports of financial institutions can give a reasonable “snapshot,” it is preferable to obtain more current data on the composition of an institution’s equity portfolio from the financial institution itself. Where such up-to-date data are unavailable, knowledge about the most frequently traded equities, as well as the stock exchange dealing and underwriting activities of the institution, can sometimes help in updating open position estimates.
