Liquidity Risk, Cash-Flow Constraints and Systemic Feedbacks

Abstract

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.

Keywords: Systemic risk, funding liquidity risk, contagion, stress testing

JEL Classification: G01, G21, G32