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Incorporating funding costs in top-down stress tests

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Abstract Central banks and supervisory authorities regularly conduct stress tests of banks. As losses accumulate in stress scenarios, banks’ equity position worsens, and they must pay higher interest rates to… Click to show full abstract

Abstract Central banks and supervisory authorities regularly conduct stress tests of banks. As losses accumulate in stress scenarios, banks’ equity position worsens, and they must pay higher interest rates to retain funding. I explore how variations of Merton-type models can be used to measure bank risk, and then examine the link between various risk measures and funding costs. Finally, I outline a method for incorporating funding cost increases into top-down stress tests.

Keywords: incorporating funding; funding costs; stress; stress tests; top stress

Journal Title: Journal of Financial Stability
Year Published: 2020

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