The paper presents a framework to integrate liquidity and solvency stress tests. An empirical study based on European bond trading data finds that asset sales haircuts depend on the total amount of assets sold and general liquidity conditions in the market. To account for variations in market liquidity, the study uses Markov regime-switching models and links haircuts with market volatility and the amount of securities sold by banks. The framework is accompanied by a Matlab program and an Excel-based tool, which allow the calculations to be replicated for any type of traded security and to be used for liquidity and solvency stress testing.
Ms. Alicia García-Herrero and Mr. Francisco F. Vazquez
This paper assembles a bank-level dataset covering the operations of 38 international banks from eight industrial countries and their subsidiaries overseas during 1995-2004, and studies the extent of diversification gains from their local operations abroad. The paper finds that international banks with a larger share of assets allocated to foreign subsidiaries, particularly to those located in emerging market countries, are able to attain higher risk-adjusted returns. These gains are somewhat reduced- but by no means depleted-when international banks concentrate their subsidiaries in specific geographical regions. The paper also finds a substantial home bias in the international allocation of bank assets, relative to the results of a mean-variance portfolio optimization model. Overall, international diversification gains in banking appear to be substantial, albeit largely unexploited by current bank expansion strategies. These results suggest that international diversification gains could usefully be considered in the second pillar of Basel II as the first pillar is based only on the idiosyncratic risk of recipient countries.