Role of Liquidity and Market Risk in Stress Testing and Systemic Risk Mitigation

Abstract

Liquidity and market risks are among the most critical sources of vulnerability in the banking system, particularly during periods of heightened economic uncertainty and financial market volatility. Effective stress testing has therefore become a central regulatory and risk management tool for identifying potential systemic weaknesses and enhancing financial resilience. This study conceptually examines the role of liquidity and market risk in stress testing frameworks and their implications for systemic risk mitigation in the banking sector. Drawing on recent academic literature and regulatory guidance published between 2020 and 2024 the paper synthesizes key insights on how liquidity and market risk factors are incorporated into stress testing scenarios and supervisory assessments. The analysis highlights that stress testing serves not only as a diagnostic tool for individual banks, but also as a mechanism for identifying interconnected risks that may threaten system-wide stability. The findings further suggest that the effectiveness of stress testing in mitigating systemic risk depends on the integration of forward-looking risk measures, robust scenario design, and strong regulatory oversight. This study contributes to the literature by providing a structured conceptual perspective on the interaction between liquidity risk, market risk, and stress testing within contemporary banking risk management frameworks.