Margin Procyclicality and Systemic Risk

Posted: 24 Apr 2017 Last revised: 30 Jan 2018

See all articles by Mohamed Bakoush

Mohamed Bakoush

University of Southampton - Southampton Business School

Enrico Gerding

University of Southampton - School of Electronics and Computer Science (ECS)

Simon Wolfe

University of Southampton - Southampton Business School

Date Written: March 10, 2017

Abstract

We develop a model in which margin procyclicality, asset market depth and banks' propensity for liquidity hoarding interact to generate a systemic liquidity crisis. In this model, banks trade derivatives to hedge market risk or to speculate on interest rate movements. To mitigate counterparty credit risk, daily mark-to-market is required which results in daily margin calls. We show that when banks holdings of high quality liquid assets are insufficient to cover a margin call, banks hoard liquidity in the interbank market. Other banks might do the same leading to a liquidity hoarding contagion that is exacerbated by high interbank connectivity. We also show that distressed banks that do not have access to the interbank market sell their less liquid assets leading to consecutive declines in the price of these assets. This fire sale contagion is more severe if collateral haircuts are excessively high. Finally, we find that the propagation of systemic risk is unaffected by whether derivatives are centrally or bilaterally cleared, assuming the same daily mark-to-market rules apply.

Keywords: Margin Procyclicality; Funding Liquidity Risk; Systemic Risk; Contagion; Networks; Agent-Based Modelling.

JEL Classification: G01; G15; G21; G28.

Suggested Citation

Bakoush, Mohamed and Gerding, Enrico and Wolfe, Simon, Margin Procyclicality and Systemic Risk (March 10, 2017). Available at SSRN: https://ssrn.com/abstract=2957420 or http://dx.doi.org/10.2139/ssrn.2957420

Mohamed Bakoush (Contact Author)

University of Southampton - Southampton Business School ( email )

Southampton, SO17 1BJ
United Kingdom

Enrico Gerding

University of Southampton - School of Electronics and Computer Science (ECS) ( email )

University Road
Southampton
United Kingdom

Simon Wolfe

University of Southampton - Southampton Business School ( email )

Southampton, SO17 1BJ
United Kingdom

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