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Liquidity risk, cash-flow constraints and systemic feedbacks

  • Kapadia, Sujit

    ()

    (Bank of England)

  • Drehmann, Mathias

    ()

    (Bank for International Settlements)

  • Elliott, John

    ()

    (Bank of England)

  • Sterne, Gabriel

    ()

    (Exotix)

The endogenous evolution of liquidity risk is a key driver of financial crises. This paper models liquidity feedbacks in a quantitative model of systemic risk. The model incorporates a number of channels important in the current financial crisis. As banks lose access to longer-term funding markets, their liabilities become increasingly short term, further undermining confidence. Stressed banks’ defensive actions include liquidity hoarding and asset fire sales. This behaviour can trigger funding problems at other banks and may ultimately cause them to fail. In presenting results, we analyse scenarios in which these channels of contagion operate, and conduct illustrative simulations to show how liquidity feedbacks may markedly amplify distress.

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Paper provided by Bank of England in its series Bank of England working papers with number 456.

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Length: 42 pages
Date of creation: 21 Jun 2012
Date of revision:
Handle: RePEc:boe:boeewp:0456
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  24. Gai, Prasanna & Haldane, Andrew & Kapadia, Sujit, 2011. "Complexity, concentration and contagion," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 453-470.
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