Liquidity Risk and Contagion
AbstractThis paper explores liquidity risk in a system of interconnected financial institutions when these institutions are subject to regulatory solvency constraints and mark their assets to market. When the market's demand for illiquid assets is less than perfectly elastic, sales by distressed institutions depress the market prices of such assets. Marking to market of the asset book can induce a further round of endogenously generated sales of assets, depressing prices further and inducing further sales. Contagious failures can result from small shocks. We investigate the theoretical basis for contagious failures and quantify them through simulation exercises. Liquidity requirements on institutions can be as effective as capital requirements in forestalling contagious failures. (JEL: G21, G28) Copyright (c) 2005 The European Economic Association.
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Bibliographic InfoArticle provided by MIT Press in its journal Journal of the European Economic Association.
Volume (Year): 3 (2005)
Issue (Month): 2-3 (04/05)
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Web page: http://www.mitpressjournals.org/jeea
Other versions of this item:
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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