Liquidity, Market Risk, and Interest Rate Risk
What this domain tests
This domain tests how banks survive cash-flow stress, measure trading and valuation risk, and manage interest rate risk in the banking book. Expect LCR and NSFR mechanics, liquidity stress testing, VaR limitations, EVE and NII sensitivity, gap analysis, and duration.
Core rules and concepts
- LCR is high-quality liquid assets divided by net cash outflows over a 30-day stress period, with a 100% minimum. Net outflows equal outflows minus eligible inflows, subject to a cap.
- NSFR is available stable funding divided by required stable funding, with a 100% minimum. It discourages short-term funding of long-term assets.
- Liquidity stress testing must consider idiosyncratic, market-wide, and combined stresses, plus contingency funding plans.
- Market risk uses VaR, expected shortfall, sensitivity measures, and backtesting. VaR estimates a loss threshold at a confidence level and horizon; it is not a maximum loss.
- IRRBB includes repricing gap, duration, EVE sensitivity, and NII sensitivity. Optionality, basis risk, and yield-curve risk can dominate simple gap measures.
Worked example
A bank holds USD 120 million of HQLA. Under stress, expected outflows are USD 100 million and eligible inflows are USD 20 million. Net cash outflows are 100 - 20 = USD 80 million, so LCR is 120/80 = 150%. If inflows had been USD 90 million, the inflow cap would prevent counting all of them; eligible inflows would be capped at 75% of outflows, or USD 75 million, producing net outflows of USD 25 million and LCR of 480%. The cap prevents unrealistic reliance on stressed inflows.
Traps that cost marks
- Treating all securities as HQLA without haircuts or operational requirements.
- Ignoring the 75% inflow cap in LCR.
- Confusing LCR with NSFR; one is short-term cash flow, the other is stable funding structure.
- Calling VaR the worst possible loss.
- Relying on a single EVE measure without NII and basis-risk analysis.