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Finance companies are required to develop a comprehensive liquidity stress testing program that considers multiple scenarios of varying degrees of stress and time horizons.
A finance company should conduct stress tests on a regular basis for a variety of short-term and long-term company-specific and general market plausible stress scenarios individually and in combination. A periodic stress test will help a company in identification of sources of potential liquidity stress and ensuring that current liquidity risk exposures remain within the established liquidity risk tolerance. Finance companies should also include sensitivity analyses in their stress testing along with scenario analysis. While scenario analyses simultaneously examine the effect of several risk factors on liquidity, sensitivity analyses test the dependence on a selected risk factor.
The assumptions underlying the behavior of the cash flows of assets, liabilities and off-balance sheet items should be clearly detailed under all stress scenarios and approved by ALCO.
The results of stress testing exercises should be compared against the stated risk tolerance of the company and used as the basis for limit setting, preparing effective contingency funding plan and adjusting liquidity risk management strategies and policies.
Stress testing results should be reviewed by senior management and along with resulting actions, be reported to and discussed with the Board of Directors.
