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Liquidity Risk and Contagion

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  • Rodrigo Cifuentes

    (Banco Central de Chile,)

  • Hyun Song Shin

    (London School of Economics,)

  • Gianluigi Ferrucci

    (Bank of England,)

Abstract

This 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 Info

Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 3 (2005)
Issue (Month): 2-3 (04/05)
Pages: 556-566

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Handle: RePEc:tpr:jeurec:v:3:y:2005:i:2-3:p:556-566

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  1. Douglas W. Diamond & Raghuram G. Rajan, 2003. "Liquidity Shortages and Banking Crises," NBER Working Papers 10071, National Bureau of Economic Research, Inc.
  2. Helmut Elsinger & Alfred Lehar & Martin Summer, 2002. "Risk Assessment for Banking Systems," Working Papers 79, Oesterreichische Nationalbank (Austrian Central Bank).
  3. Milgrom, Paul & Roberts, John, 1994. "Comparing Equilibria," American Economic Review, American Economic Association, vol. 84(3), pages 441-59, June.
  4. Morris, Stephen & Shin, Hyun Song, 1999. "Risk Management with Interdependent Choice," Oxford Review of Economic Policy, Oxford University Press, vol. 15(3), pages 52-62, Autumn.
  5. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  6. Jackson, Patricia & Perraudin, William & Saporta, Victoria, 2002. "Regulatory and "economic" solvency standards for internationally active banks," Journal of Banking & Finance, Elsevier, vol. 26(5), pages 953-976, May.
  7. Schnabel, Isabel & Shin, Hyun Song, 2001. "Foreshadowing LTCM: The Crisis of 1763," Sonderforschungsbereich 504 Publications 02-46, Sonderforschungsbereich 504, Universit├Ąt Mannheim & Sonderforschungsbereich 504, University of Mannheim.
  8. C. H. Furfine, 1999. "Interbank exposures: quantifying the risk of contagion," BIS Working Papers 70, Bank for International Settlements.
  9. Upper, Christian & Worms, Andreas, 2004. "Estimating bilateral exposures in the German interbank market: Is there a danger of contagion?," European Economic Review, Elsevier, vol. 48(4), pages 827-849, August.
  10. George Sheldon & Martin Maurer, 1998. "Interbank Lending and Systemic Risk: An Empirical Analysis for Switzerland," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 134(IV), pages 685-704, December.
  11. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
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