Introducing Funding Liquidity Risk in a Macro Stress-Testing Framework

The main contribution of this paper is to introduce a funding liquidity component `a la Morris and Shin (2009) in a stresstesting framework. As a result, funding liquidity risk arises as an endogenous outcome of the interactions between market liquidity and solvency risks, and banks’ liquidity profiles. We perform a calibration exercise that highlights the vulnerability of leveraged institutions to the combination of low cash holdings and the prevalence of short-term debt, a key feature of the 2008 credit crisis. We also analyze the trade-offs between higher capital ratios, more liquid assets, and/or less short-term liabilities in reducing systemic risk.