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.
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Bibliographic InfoPaper provided by Bank of England in its series Bank of England working papers with number 264.
Date of creation: May 2005
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2005-07-03 (All new papers)
- NEP-CFN-2005-07-03 (Corporate Finance)
- NEP-CMP-2005-07-03 (Computational Economics)
- NEP-RMG-2005-07-03 (Risk Management)
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