Effective Liquidity Stress Testing Starts with a Coherent Narrative

One of the most common pitfalls in liquidity stress testing is using scenarios that escalate in severity but lack internal consistency.

Too often, I see liquidity stress test scenarios built by simply layering on more severe assumptions. For example, deposit outflows get larger, credit losses rise, and borrowing capacity tightens. But these are modeled without unifying logic. The assumptions escalate, but they don’t align. The result is a set of scenarios that contradict themselves and lack a coherent, realistic narrative.

🖊️ Here’s the key point:

Stress testing isn’t about predicting the future.

The scenarios you model will almost never play out exactly as designed.

What stress testing is about is using thoughtful, plausible scenarios to help you identify where the vulnerabilities lie on your balance sheet. It’s a risk discovery tool. not a forecasting tool.

And that only works when your scenarios are realistic and internally consistent.

Some examples:

💥 Idiosyncratic event

You model a loss of confidence in your institution due to a fraud event that leads to uninsured deposit runoff. Makes sense.

But you also assume stable credit quality and unchanged collateral haircuts at the FHLB. That’s not realistic. An event that shakes depositor confidence would likely impact credit perception and borrowing conditions.

📉 Market-wide liquidity crunch

You assume stress across the banking system, deposits are flowing out, wholesale markets are dry.

But somehow, your FHLB advance availability and terms don’t change? In a real crisis, haircuts increase, and collateral gets discounted more aggressively.

📊 Credit deterioration scenario

You model rising delinquencies and charge-offs. But deposit levels hold steady or even rise.

In reality, economic deterioration and credit losses often drive deposit outflows, especially from large or uninsured accounts.

💡 The Solution: Start with a plausible story. What is happening in the scenario, and why? Then shape the assumptions around that narrative.

Stress testing done right is about identifying potential weaknesses and pressure points, not gaming the inputs for severity’s sake. If the narrative doesn’t hold together, neither will your insights.