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Liquidity Risk and Contagion

  • Rodrigo Cifuentes

    (Banco Central de Chile,)

  • Hyun Song Shin

    (London School of Economics,)

  • Gianluigi Ferrucci

    (Bank of England,)

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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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. 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.
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  4. 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.
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  7. Douglas W. Diamond & Raghuram G. Rajan, 2002. "Liquidity Shortages and Banking Crises," NBER Working Papers 8937, National Bureau of Economic Research, Inc.
  8. C. H. Furfine, 1999. "Interbank exposures: quantifying the risk of contagion," BIS Working Papers 70, Bank for International Settlements.
  9. 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.
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