MORE WIDE-RANGING stress testing, better integration of contingency funding and capture of off-balance sheet funding as well as taking reputation risk more into account were among the lessons learned from the current financial turmoil, according to the Bank of International Settlements.
A working group on liquidity at the BIS’s Basel Committee on Banking Supervision said last month inadequate stress testing by the financial sector meant the nature, magnitude and duration of the shock caused by the loss of liquidity and squeeze on credit stemming from the subprime mortgage defaults had been underestimated.
Prior to the start of the present funding shocks, “in most cases, stress testing had focused on idiosyncratic or firm specific shocks,” the working group said.
“Although that still had some value, and preparations for name-specific events, such as inability to access wholesale markets for a period, aided resilience, recent events demonstrated that stress tests should also capture the implications of wider disruptions.”
This included testing scenarios that had a combination of “idiosyncratic and market-wide shocks” which incorporate the behavioural responses of other affected banks.
However, the working group noted some banking supervisors had met with resistance when they tried to encourage more rigorous and comprehensive stress testing prior to the credit crunch.
As a result, it said defining appropriate levels of stress testing is still a “formidable challenge” for banks and supervisors.
Stress tests have also not been integrated sufficiently with contingency funding plans, and in fact many of the contingency fund options banks had assumed they would be able to use were also the source of the funding shock now hitting institutions around the world.
“Banks had made assumptions about the asset market liquidity of certain structured products, ABCP [asset-backed commercial paper] and loan books that proved to be overly optimistic,” it said.
“They had often assumed continuous high liquidity of these markets, and indeed some had treated mortgage securitisation and ABCP as very resilient support facilities and core backstops in the event of funding difficulties.”
The report says the maintenance of adequate credit remains important to allow the absorption of unexpected losses, however it noted even large banks with considerable credit reserves can still face severe liquidity problems.
Prudential and market supervisors also need to collect and analyse information on stress testing more quickly.
The BCBS is now updating the Sound Practices for Managing Liquidity in Banking Organisations to reflect some of the lessons learned, and will release an exposure draft later in the year.