Central Bank of Luxembourg publishes research developing a system-wide stress testing framework for Luxembourg banks and investment funds

The Central Bank of Luxembourg has published Cahier d’études No. 199 by José Fique and Xisong Jin, setting out a structural framework for system-wide stress testing to assess the resilience of Luxembourg’s financial sector and identify vulnerabilities across banks and investment funds through interacting liquidity and solvency channels. Using hypothetical adverse scenarios, the analysis finds sizeable first-round and higher-order effects for investment funds, particularly equity funds, while the impact on Luxembourg banks is substantially more limited, with low aggregate capital depletion even under very severe risk materialisation. The framework builds on the European Central Bank’s stress-testing approach and adds flow-performance feedbacks as well as investment fund liquidity management features, including leverage and targeted cash holdings, while jointly capturing market, credit and liquidity risks with dynamic balance-sheet adjustment, regulatory constraints and endogenous market price formation. It covers almost all Luxembourg banks excluding branches and three large investment fund categories (equity, bond and mixed), with shocks designed to resemble episodes similar to the Global Financial Crisis, the sovereign debt crisis and the COVID-19 pandemic; bond funds exhibit a higher amplification factor than other fund types, and vulnerabilities for both banks and funds continue to reflect procyclicality. The paper notes that the views expressed are those of the authors and not necessarily those of the Central Bank of Luxembourg or the Eurosystem.