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Liquidity Spirals

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  • Farmer, J. Doyne
  • Wiersema, Garbrand
  • Kemp, Esti

Abstract

We introduce a novel method for studying liquidity spirals and use this method to identify spirals before stock prices plummet and funding markets lock up. We show that liquidity spirals may be underestimated or completely overlooked when interactions between contagion channels are ignored, and find that financial stability is greatly affected by how institutions choose to respond to liquidity shocks, with some strategies yielding a \robust-yet-fragile" system. To demonstrate the method, we apply it to a highly granular data set on the South African banking sector and investment fund sector. We find that liquidity spirals are exacerbated when the liquidity positions of institutions worsen, and that central bank-provided liquidity can greatly dampen liquidity spirals. We also show that, depending on the market conditions, a liquidity spirals is sometimes caused by the banking and fund sectors' collective dynamics, but at other times by one sector's individual impact. The approach developed here can be used to formulate interventions that specifically target the sector(s) causing the liquidity spiral.

Suggested Citation

  • Farmer, J. Doyne & Wiersema, Garbrand & Kemp, Esti, 2023. "Liquidity Spirals," INET Oxford Working Papers 2023-16, Institute for New Economic Thinking at the Oxford Martin School, University of Oxford.
    • Handle: RePEc:amz:wpaper:2023-16
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    File URL: https://www.inet.ox.ac.uk/files/Liquidity-Spirals-20230906.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Liquidity Spiral; Financial Stability; Systemic Risk; Financial Contagion; Interacting Contagion Channels; Intersectoral Contagion Channels; Multiplex Networks; Stress Test; Solvency-Liquidity Nexus;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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