System-wide financial stress testing has become an essential framework for assessing the resilience of the financial system, both in the academic literature and in the conduct of macroprudential policy. The process consists of assessing the ability of the financial system to absorb shocks while keeping its essential functions operational. Given the increasing complexity of the Luxembourg financial system and the diversity of its players, it is important to strengthen the supervision of the financial sector in Luxembourg from a systemic perspective. Such a system-wide perspective would also be appropriate for other complex foreign financial systems.

This study develops a structural framework for system-wide endurance testing, integrating multiple channels of contagion and amplification that interact via the interaction of liquidity and solvency risk. This framework makes it possible to identify vulnerabilities emanating from banks and investment funds in Luxembourg. It is based on the stress testing framework developed by the ECB by integrating the relationship between flows and returns, and the liquidity management of investment funds with both leverage and targeted cash flow objectives, on the other. By simultaneously capturing market, credit and liquidity risks, the framework adopted highlights the interactions between liquidity and solvency, allowing for dynamic balance sheet adjustments, advanced integration of regulatory constraints and endogenous market price formation.

The study covers almost all banks (excluding branches) and three main categories of investment funds in Luxembourg: equity funds, bond funds and mixed funds. Exogenous shocks arise from hypothetical adverse scenarios, similar to those of the Great Financial Crisis, the sovereign debt crisis, and the recent COVID-19 pandemic. Several stylised facts are described for banks and the three categories of investment funds over the period 2020-2023. First, simulated shocks have significant first-round and higher-order effects on investment funds, particularly equity funds. In addition, bond funds have a higher amplification factor than other types of funds. Secondly, the impact on Luxembourg banks is significantly mitigated. The overall depletion of banks' capital, as measured by the total amount of risk exposure, remains low even in the case of a very severe risk. This reflects the robustness of the Luxembourg banking sector as a whole. Finally, for both investment funds and banks, their vulnerabilities continue to reflect the procyclicality of the financial system. In view of these results, the joint modelling of banks and non-bank financial entities brings real added value to the analytical capacities of central banks and informs policymakers in the development of future macroprudential tools for the non-bank intermediary sector.

The content of this study should not be seen as representative of the views of the Banque centrale du Luxembourg or the Eurosystem. The views expressed reflect those of the authors and do not necessarily reflect the position of the Central Bank, its management or the Eurosystem.

This study book is available on the BCL website: www.bcl.lu