Tuesday, August 9, 2011
Liquidity risk cannot be treated satisfactorily by the VAR because it ignores the risk exposure of a portfolio during the process of its liquidation. A liquidity crisis is usually an extreme event, so it requires tools Stress testing more appropriate than the VaR.
To fight against liquidity crises, the scenarios of crisis of a financial institution must include all the fragility of its balance sheet, namely the possible mismatch between investments in illiquid assets and funding sources precarious liabilities. A Stress Test relevant to a financial institution would be important to consider the consequences of a simultaneous withdrawal of its market counterparties. This is the way in which JP Morgan is committed after the near-collapse of LTCM in 1998. JP Morgan has developed the "dealer exit stress tests" to estimate the risk of sudden drying up of market liquidity due to one or more of their counterparties. This kind of stress tests and allowed to become aware of the dangers of the high concentration of certain financial markets.
One of the limitations of VaR as originally calculated was based on an assumption of "normality" of events. Or rare events are more important in magnitude than the law says normal. The work was therefore directed towards the use of distributions from "fat tails". Stress Testing procedure has the advantage of circumventing this difficulty by specifying the desired magnitude of the event, regardless of its probability of occurrence. Therefore it is considered an extension of the VaR.
Although complementary, these two methods have significant differences, however, since they are far from operating in the same period. Indeed, while the VaR is a tool for highly automated daily monitoring, Stress Testing requires the intervention of a number of players and often requires a significant delay construction and analysis. Thus, if the answer to a VaR limit is exceeded is simple (just cut positions), the response to overexposure through a liquidity stress analysis is more complex (installation program or refinancing guarantees, etc.)..
Finally, unlike the VaR with the automatic calculation can facilitate the adoption of the outcome, the results of stress testing because they are developed from subjective elements, require a real effort to communicate and explain with decision-making bodies.