Maintaining Confidence

Abstract

This paper proposes the solvency/liquidity spiral as an failure mode affecting large financial institutions in the recent crisis. The essential features of this mode are that a combination of funding liquidity risk and investor doubts over the solvency of an institution can lead to its failure.

We analyse the failures of Lehman Brothers and RBS in detail, and find considerable support for the spiral model of distress.Our model suggests that a key determinant of the financial stability of many large banks is the confidence of the funding markets. This has consequences for the design of financial regulation, suggesting that capital requirements, liquidity rules, and disclosure should be explicitly constructed so as not just to mitigate solvency risk and liquidity risk, but also to be seen to do so even in stressed conditions.

Keywords: Liquidity risk, bank failure, capital regulation, solvency risk

JEL Classification: G28