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Margin requirements and systemic liquidity risk

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  • Bakoush, Mohamed
  • Gerding, Enrico H.
  • Wolfe, Simon

Abstract

We develop a model in which margin procyclicality and the propensity for liquidity hoarding interact to generate a systemic liquidity crisis. In this model, banks lend and borrow in the interbank market to mitigate liquidity risk and trade derivatives contracts in the OTC derivatives market to mitigate market risk. The daily mark-to-market of derivatives contracts results in daily margin calls that banks cover using high quality liquid assets. We find that distress due to margin procyclicality in the derivatives market can spillover to the interbank market leading to systemic liquidity risk. Interconnectedness further amplifies the effects of systemic risk within the interbank market. The model shows that central clearing might increase the possibility of systemic liquidity risk due to tight margin requirements and the timing of cash flows required from banks. We also find that haircut levels affect the possibility of systemic liquidity risk, and highlight the potential role of a market maker of last resort in limiting this possibility.

Suggested Citation

  • Bakoush, Mohamed & Gerding, Enrico H. & Wolfe, Simon, 2019. "Margin requirements and systemic liquidity risk," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 58(C), pages 78-95.
  • Handle: RePEc:eee:intfin:v:58:y:2019:i:c:p:78-95
    DOI: 10.1016/j.intfin.2018.09.007
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    Keywords

    Margin procyclicality; Funding liquidity risk; Systemic risk; Contagion; Networks; Agent-based modelling;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • 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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