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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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  1. Jens H. E. Christensen & Jose A. Lopez & Glenn D. Rudebusch, 2014. "Do Central Bank Liquidity Facilities Affect Interbank Lending Rates?," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 32(1), pages 136-151, January.
  2. Heider, Florian & Hoerova, Marie & Holthausen, Cornelia, 2010. "Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk," CEPR Discussion Papers 7762, C.E.P.R. Discussion Papers.
  3. Mathias Drehmann, 2002. "Will an optimal deposit insurance always increase financial stability?," Bonn Econ Discussion Papers bgse28_2002, University of Bonn, Germany.
  4. Murillo Campello & Erasmo Giambona & John R. Graham & Campbell R. Harvey, 2010. "Liquidity Management and Corporate Investment During a Financial Crisis," NBER Working Papers 16309, National Bureau of Economic Research, Inc.
  5. David Aikman & Piergiorgio Alessandri & Bruno Eklund & Prasanna Gai & Sujit Kapadia & Elizabeth Martin & Nada Mora & Gabriel Sterne & Matthew Willison, 2009. "Funding Liquidity Risk in a Quantitative Model of Systemic Stability," Working Papers Central Bank of Chile 555, Central Bank of Chile.
  6. Acharya, Viral V. & Skeie, David, 2011. "A model of liquidity hoarding and term premia in inter-bank markets," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 436-447.
  7. Helmut Elsinger & Alfred Lehar & Martin Summer, 2006. "Risk Assessment for Banking Systems," Management Science, INFORMS, vol. 52(9), pages 1301-1314, September.
  8. Ilhyock Shim & Goetz von Peter, 2007. "Distress selling and asset market feedback," BIS Working Papers 229, Bank for International Settlements.
  9. Piergiorgio Alessandri & Prasanna Gai & Sujit Kapadia & Nada Mora & Claus Puhr, 2009. "Towards a Framework for Quantifying Systemic Stability," International Journal of Central Banking, International Journal of Central Banking, vol. 5(3), pages 47-81, September.
  10. Acharya, Viral V & Merrouche, Ouarda, 2012. "Precautionary hoarding of liquidity and inter-bank markets: Evidence from the sub-prime crisis," CEPR Discussion Papers 8859, C.E.P.R. Discussion Papers.
  11. Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
  12. Paolo Angelini & Andrea Nobili & Maria Cristina Picillo, 2009. "The interbank market after August 2007: what has changed, and why?," Temi di discussione (Economic working papers) 731, Bank of Italy, Economic Research and International Relations Area.
  13. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
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