Liquidity Risk and Contagion

31 Pages Posted: 19 Oct 2005

See all articles by Rodrigo Cifuentes

Rodrigo Cifuentes

Central Bank of Chile

Gianluigi Ferrucci

European Central Bank (ECB)

Hyun Song Shin

Bank for International Settlements (BIS)

Date Written: May 2005


This paper explores liquidity risk in a system of interconnected financial institutions when these institutions are subject to regulatory solvency constraints and mark their assets to market. When the market's demand for illiquid assets is less than perfectly elastic, sales by distressed institutions depress the market prices of such assets. Marking to market of the asset book can induce a further round of endogenously generated sales of assets, depressing prices further and inducing further sales. Contagious failures can result from small shocks. We investigate the theoretical basis for contagious failures and quantify them through simulation exercises. Liquidity requirements on institutions can be as effective as capital requirements in forestalling contagious failures.

Suggested Citation

Cifuentes, Rodrigo and Ferrucci, Gianluigi and Shin, Hyun Song, Liquidity Risk and Contagion (May 2005). Bank of England Working Paper Series No. 264, Available at SSRN: or

Rodrigo Cifuentes

Central Bank of Chile ( email )

Agustinas 1180

Gianluigi Ferrucci (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314

Hyun Song Shin

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002


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