# ICAAP: Stress Test: Liquidity Risk

In this post we will be covering some of the ways in which liquidity risk may be stress tested under the Internal Capital Adequacy and Assessment Process (ICAAP). These involve simple sensitivity analysis techniques, such as applying liquidity and interest rate shocks to the assets and liabilities of the bank.

## Simple Sensitivity Analysis

### Liquidity shocks

The stress test for liquidity risk evaluates the resilience of the banks towards the fall in liquid liabilities. Steps for carrying out the liquidity shock stress test are given below:

• Classify the assets and liabilities on the balance sheet as liquid or illiquid
• Calculate the net liquid assets and net liquid liabilities
• Apply 10% shock using the following procedure:
• Fall in liquid liabilities = Liquid Liabilities * 0.1
• Revised Liquid Assets = liquid Assets – Fall in liquid liabilities
• Revised Liquid Liabilities = Liquid Liabilities – Fall in liquid liabilities
• Revised Ratio (%) = (Revised Liquid Assets / Revised Liquid Liabilities)*100
• Repeat the procedure for a 20% and 30% shocks respectively

### Interest Rate Shocks

Interest rate risk is the potential that the value of the on-balance sheet and the off-balance sheet positions of the institution would be negatively affected with the change in the interest rates. The vulnerability of an institution towards the adverse movements of the interest rate can be gauged by using the duration GAP analysis.

Interest rate risk is the potential that the value of the on-balance sheet and the off-balance sheet positions of the institution would be negatively affected with the change in the interest rates. The vulnerability of an institution towards the adverse movements of the interest rate can be gauged by using the duration GAP analysis.

Interest rate stress test can be carried out using the following procedure:

• Identify Interest rate sensitive assets and liabilities. Additionally, non – interest rate bearing items can also be included in calculation.
• Calculate the MTM value for all the rate sensitive assets.
• Calculate the MTM value for all the rate sensitive liabilities.
• Calculate the duration for each asset and liability of the on-balance sheet portfolio:
• Calculate the Duration value for each item using the Macaulay’s duration.

• Calculate CAR
• CAR will be calculated using the following formula:
• Tax Adjusted Loss = DNMVE * (1 – Tax Rate)
• Revised Regulatory Capital = Total Regulatory Capital – Tax Adjusted Loss
• Revised risk weighted assets = Total Risk Weighted Assets – Tax Adjusted Loss
• Revised CAR(%) = Revised Regulatory Capital / Revised risk weighted assets
• Original CAR(%) =  Total Regulatory Capital /Total Risk Weighted Assets
• Fall in CAR(% age points) = Original CAR – Revised CAR

Where,