Econometric Modeling for Liquidity Stress Testing Under Basel III: A Dynamic Panel Data Approach

Abstract

With the advent of Basel III banking regulatory standards and the growing complexity of financial markets, banking institutions have incorporated liquidity risk as a key consideration. The importance of effective liquidity stress testing for assessing a bank's capacity to absorb adverse economic and financial conditions and to sustain its funding and operations. This study sets up an econometric framework for liquidity stress testing based on dynamic panel data model and discusses the factors that affect the liquidity resilience of banking institutions. The proposed model includes both financial variables related to the bank and macroeconomic variables, in order to reflect the persistence and dynamics of the liquidity situation over time. To overcome the endogeneity, unobserved heterogeneity and serial dependence problems, dynamic panel estimation methods are used to achieve greater reliability in empirical estimates. This framework assesses the impact of sources and uses of liquidity, capital levels, profitability, funding structure and macro-economic conditions on the liquidity stress under various stress scenarios. The results should be solid for the purposes of improving liquidity risk management, improving the macroprudential supervision framework and for regulatory decision making. The study adds to the literature by providing an integrated econometric model that can aid in the ability to more accurately predict liquidity stress-test outcomes and enhance resilience in the financial system in the current and future regulatory and economic landscapes.