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A Market Risk Approach to Liquidity Risk and Financial Contagion

Listed author(s):
  • Dairo Estrada

    ()

  • Daniel Osorio

    ()

Registered author(s):

    According to traditional literature, liquidity risk in individual banks can turn into a wide-system financial crisis when either interbank credit exposures or bank runs are present. This paper shows that this phenomenon can also arise when individual liquidity risk transforms into wide-system marketrisk (even in the absence of bank runs and interbank credit networks). This happens when banks try to sell some portion of its assets in order to overcome a liquidity shortage (individual liquidity risk). These sales depress the market price of assets if demand is not perfectly elastic. Given the fact thatbanks mark to market the asset book, the fall of market price reduces the value of assets of every bank in the system (wide-system market risk), leaving them less suited for future liquidity shortages and therefore more prone to bankruptcies. The paper rationalizes this idea through the simulation of a model that tries to capture the behavior of a liquidity manager that faces shocks on bank deposits and loans. The main results suggest that the extentof financial contagion depends crucially on the size of the market for assets.

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    File URL: http://www.banrep.gov.co/sites/default/files/publicaciones/archivos/espe_050-6.pdf
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    Article provided by BANCO DE LA REPÚBLICA - ESPE in its journal ENSAYOS SOBRE POLÍTICA ECONÓMICA.

    Volume (Year): 24 (2006)
    Issue (Month): 50 (June)
    Pages: 242-271

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    Handle: RePEc:col:000107:007512
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    1. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    2. Xavier Freixas & Bruno Parigi & Jean-Charles Rochet, 2000. "Systemic risk, interbank relations, and liquidity provision by the central bank," Proceedings, Federal Reserve Bank of Cleveland, pages 611-640.
    3. C. H. Furfine, 1999. "Interbank exposures: quantifying the risk of contagion," BIS Working Papers 70, Bank for International Settlements.
    4. De Bandt, Olivier & Hartmann, Philipp, 2000. "Systemic risk: A survey," Working Paper Series 0035, European Central Bank.
    5. Dimitrios P. Tsomocos, 2003. "Equilibrium analysis, banking, contagion and financial fragility," LSE Research Online Documents on Economics 24826, London School of Economics and Political Science, LSE Library.
    6. Rochet, Jean-Charles & Tirole, Jean, 1996. "Interbank Lending and Systemic Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 733-762, November.
    7. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-781, December.
    8. Tsomocos, Dimitrios P., 2003. "Equilibrium analysis, banking and financial instability," Journal of Mathematical Economics, Elsevier, vol. 39(5-6), pages 619-655, July.
    9. Giulia Iori & Saqib Jafarey & Francisco Padilla, 2003. "Interbank Lending, Reserve Requirements and Systemic Risk," Modeling, Computing, and Mastering Complexity 2003 17, Society for Computational Economics.
    10. Craig Furfine, 1999. "Interbank exposures: quantifying the risk of contagion," Proceedings 633, Federal Reserve Bank of Chicago.
    11. Isabel Schnabel & Hyun Song Shin, 2004. "Liquidity and Contagion: The Crisis of 1763," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 929-968, December.
    12. Hasan, Iftekhar & Dwyer, Gerald P, Jr, 1994. "Bank Runs in the Free Banking Period," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(2), pages 271-288, May.
    13. Steven C. Salop, 1979. "Monopolistic Competition with Outside Goods," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 141-156, Spring.
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