Discuss the link between planning for contingent funding and the results of liquidity stress tests.
The idea
Stress tests and the contingency funding plan (CFP) are two halves of one process. A liquidity stress test measures how large, how fast and in which currencies cash would drain under defined scenarios, and how much of the liquidity buffer is still usable after haircuts. The CFP is the response: it lists the actions, owners and timing that cover the shortfall the stress test reveals. So the stress test sets the size and speed the plan must meet. If the survival horizon is shorter than the board's minimum, the plan needs faster actions or a bigger buffer. The link also runs backwards, because the cost of actions such as fire-sale discounts should feed later tests. The exam point: compare capacity with the shortfall period by period, not only in total, using stress-consistent haircuts.
Formulas
Shortfall the contingency funding plan must cover
Shortfall = Outflows − Buffer × (1 − h)
- Outflows
- cumulative stressed net outflows over the horizon
- Buffer
- the liquidity buffer at market value
- h
- the stressed haircut on the buffer
Use the stress test's haircut, not the normal one, and check the shortfall period by period: actions that cannot deliver in time do not cover early outflows.
A practice question
A bank's stress test shows that its liquidity buffer lasts 12 days, while the board's minimum survival horizon is 30 days. Which is the most appropriate response for the contingency funding plan?
- Add faster, larger contingent actions or a bigger buffer to cover days 12 to 30. - correct
- Leave the plan unchanged, because the stress scenario is by definition too severe to be relevant to planning.Why not: Dismisses the stress result: the purpose of the test is to expose such gaps, and the plan must be built around them.
- Lower the stress assumptions until the survival horizon reaches 30 days, so the plan meets the board limit.Why not: Tunes the test to hit the limit instead of fixing the plan, which hides the risk rather than covering it.
- Extend the plan's horizon to 12 days only, since actions beyond the buffer's life are not needed.Why not: Reverses the logic: the plan matters most for the period after the buffer is exhausted, so it must cover days 12 to 30.
A survival horizon of 12 days against a 30-day minimum leaves 18 days uncovered. The CFP must supply actions that deliver cash in that window, or the buffer must grow.
A harder one
A bank's 30-day stress test shows cumulative net outflows of USD 800 million. Its liquidity buffer has a market value of USD 600 million and the stress test applies a 15% haircut to it. What shortfall must the CFP's actions cover over 30 days?
- USD 200 millionWhy not: Ignores the haircut: 800 - 600 treats the buffer at full market value although it would realise only 85% in stress.
- USD 710 millionWhy not: Subtracts the haircut amount (15% of 600 = 90) rather than the post-haircut buffer: 800 - 90.
- USD 800 millionWhy not: Ignores the buffer entirely: the buffer is the first line of defence and reduces the shortfall the plan must cover.
- USD 290 million - correct
Usable buffer = 600 x (1 - 0.15) = 510. Shortfall = 800 - 510 = 290. The CFP must identify at least USD 290 million of additional funding.
The hardest tier
A bank's stress test has a liquidity buffer of USD 1,200 million market value, with a 15% haircut in stress. Stressed net outflows are USD 180 million per day on days 1 to 3, USD 90 million per day on days 4 to 10 and USD 60 million per day after that. What is the survival horizon, the last full day on which cumulative net outflows are covered by the usable buffer, closest to?
- 8 days - correct
- 9 daysWhy not: Counts the day on which the buffer is breached: cumulative outflow reaches 1,080 on day 9, which exceeds the usable 1,020.
- 10 daysWhy not: Uses the buffer at full market value (1,200) with no haircut: that would last to day 10.
- 5 daysWhy not: Applies the day-1 outflow of 180 as a flat rate: 1,020 / 180 = 5.7, ignoring the lower outflows from day 4.
Usable buffer = 1,200 x 0.85 = 1,020. Cumulative outflow: 540 after day 3, then 90 a day gives 990 on day 8 and 1,080 on day 9. The buffer covers 8 full days, so CFP actions must deliver cash from day 9.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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