How should institutions quantify liquidity risk under stress?

Quantifying liquidity risk under stress requires integrating cash flow projection, market liquidity measures, and governance frameworks into scenario-based stress tests that are credible, auditable, and sensitive to local conditions. The Basel Committee on Banking Supervision Bank for International Settlements emphasizes liquidity coverage and stable funding as core quantitative anchors while urging institutions to supplement these with institution-specific stress assumptions. Academic research by Darrell Duffie Stanford Graduate School of Business highlights how market liquidity can evaporate rapidly and produce fire-sale dynamics that amplify funding stress, underscoring the need to model interactions between funding and market liquidity.

Scenario construction and projection
Stress quantification should begin with clearly defined scenarios that capture idiosyncratic shocks such as a run on deposits, market-wide shocks like a sovereign or corporate credit event, and combined stress where funding lines dry up while asset prices fall. Projections must be granular by currency and legal entity, mapping contractual and behavioural cash inflows and outflows across multiple horizons. Behavioral assumptions for retail and wholesale funds should be evidence-based and updated with recent experience, reflecting differences in depositor stickiness across cultures and territories that empirical studies and supervisory guidance identify as material.

Market liquidity and haircut modeling
Institutions need dynamic measures of market liquidity including bid-ask spreads depth and resilience, and models for haircut widening under stress. Research on fire sales shows that nominal asset values can diverge from recoverable liquidity in stressed conditions, so models must link price impacts to trading volumes and market structure. Collateral valuation models ought to incorporate stress haircuts and operational constraints on rehypothecation, with parameters calibrated to observable stress episodes and to central bank facility terms where applicable.

Contingency and governance considerations
Quantification is incomplete without contingency funding plans that specify pre-positioned collateral access lines and playbooks for central bank liaison. Senior management and the board must set risk tolerances and approve stress assumptions, while treasury and risk functions run regular reverse stress tests to identify scenarios that would deplete usable liquidity. Supervisory frameworks demand transparency in assumptions and back-testing against historical episodes to maintain credibility.

Human, cultural and territorial nuances
Local deposit behavior, regulatory backstops and market infrastructure shape exposure. In some regions household deposits are highly loyal and reduce run risk while in others short-term wholesale markets dominate funding profiles. Environmental events such as natural disasters concentrated in a territory can produce acute local liquidity demand for corporates and households and thus for banks. Cultural expectations about government support and differences in central bank facilities will also affect the probability of severe outcomes, so models must be tailored to jurisdictional realities.

Consequences of underquantification include forced asset sales, contagion across institutions and reputational damage that limits future funding. Robust quantification anchored in supervisory guidance from the Basel Committee on Banking Supervision Bank for International Settlements and informed by academic insights from Darrell Duffie Stanford Graduate School of Business helps institutions measure, communicate and mitigate liquidity risk before stress crystallizes.