Liquidity Risk and Contagion

Abstract

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.

Fire Sales, Indirect Contagion and Systemic Stress-Testing

“…In Greenwood et al (2015) this was addressed by capping the loss at 100%: Ψ µ (q) = min 1, q Dµ . Cifuentes et al (2005) use an exponential specification…”

The Effect of Heterogeneity on Financial Contagion Due to Overlapping Portfolios

“…We assume a market impact function of the form f j (x j ) = e −αx j as in [20,3,17] such that x j is the liquidated fraction of asset j. The price of asset j is then updated according to the rule:…”

“…The 2007 quant crisis, for instance, was caused by a similar scenario in which the fire sales liquidation of the portfolio of one equity hedge fund depressed prices of assets held by other funds causing them to embark on additional rounds of selling which depressed asset prices even further and resulted in large portfolio losses (see [31] for an elaborate discussion). The existing literature on overlapping portfolios have only considered bank interlinkages in the context of a single asset [17,36,20,3]. However, [15] have recently generalised the fire sales model introduced in [17] to the case of many assets.…”

“…The existing literature on overlapping portfolios have only considered bank interlinkages in the context of a single asset [17,36,20,3]. However, [15] have recently generalised the fire sales model introduced in [17] to the case of many assets. They characterised the stability of the financial system in terms of its structural properties including average degree, market crowding, leverage and market impact using a bipartite financial network model in which the contagion channel is formed through local portfolio overlaps between banks with homogeneous degrees.…”

Sensitivity of the Eisenberg-Noe Clearing Vector to Individual Interbank Liabilities

“…Moreover, extensions of this model have been developed to include effects such as fire sales (e.g. Cifuentes et al (2005), Nier et al (2007), Gai and Kapadia (2010), Chen et al (2016), Amini et al (2016a,b), Weber and Weske (2017), Feinstein (2017a), Feinstein and El-Masri (2017), Feinstein (2017b), Di Gangi et al (2015)), cross-ownership (e.g. Elsinger (2009), Elliott et al (2014), Weber and Weske (2017)), bankruptcy costs (e.g.…”