What Are Internal Liquidity Stress Tests?
Beyond the regulatory LCR, large banks are required to conduct Internal Liquidity Stress Tests (ILSTs) — proprietary models that simulate liquidity demands under a range of scenarios across multiple time horizons: overnight, 30 days, 90 days, and one year. Banks use ILSTs to calibrate their internal liquidity buffers, and supervisors review ILST results as part of the examination process.
Critically, while the public LCR only covers the 30-day horizon, bank ILSTs generate liquidity survival requirements across all four horizons. The most binding of these — whichever produces the largest required buffer — effectively determines a bank's actual reserve and liquid asset holdings.
The Asymmetric Treatment Problem
Current supervisory expectations for ILSTs create a significant asymmetry: discount window inflows are permissible as a liquidity source at the 90-day and one-year horizons but are generally not counted at the overnight and 30-day horizons. This exclusion at short horizons reflects historical supervisory conservatism rooted in discount window stigma — regulators assumed banks would not actually borrow from the window in a short-term stress event.
The result: the overnight and 30-day ILST scenarios often bind before the 90-day scenario does, and these binding scenarios do not credit available discount window capacity. Banks therefore must hold more reserves and HQLA to satisfy short-horizon ILST requirements than would be necessary if window borrowing were recognized across all horizons consistently.
The Policy Option
Update supervisory expectations — via interagency guidance or Fed SR letters — to allow banks to count pre-positioned discount window borrowing capacity as an inflow at both the overnight and 30-day ILST horizons, subject to operational criteria (collateral must be pledged, borrowing authority tested within the prior 12 months, operational contacts maintained).
This change would directly reduce the reserve and HQLA requirements generated by short-horizon ILST scenarios, potentially shifting the binding constraint from the overnight or 30-day horizon back to the longer horizons where banks already credit discount window capacity.
Connection to Discount Window Stigma
This reform is mechanically linked to stigma reduction. If supervisors formally validate discount window borrowing as a short-term liquidity source in ILST frameworks, the implicit supervisory message is that window access is reliable and expected — not a signal of distress. This behavioral externality may produce reserve-demand reductions beyond the purely mechanical effect of crediting window capacity in the ILST model.
The paper notes that the Borrower-in-Custody (BIC) programme — where banks pledge loan collateral at the window without actually borrowing — has expanded significantly since 2020, suggesting banks are increasingly engaged in operational readiness. Formalising ILST credit for this pre-positioning would reward and accelerate that trend.
Estimated as partial overlap with Option 01 (LCR reform); some portion of this estimate may double-count if both options are adopted simultaneously.
Overlap with Option 01
The paper explicitly cautions that the estimates for Options 01, 02, and 03 are not simply additive. Many banks are constrained by either the LCR or their ILST — not both simultaneously. If Option 01 (LCR reform) is implemented, it may already relax the constraint that Options 02 and 03 target. The combined effect of all three options likely falls below the sum of individual estimates, due to substitution between the binding regulatory constraints.
Nonetheless, each option addresses a distinct institutional pathway — LCR rules, supervisory culture, and internal model design — and all three are recommended in the paper as a complementary package.