Liquidity risk and contagion

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 12 May 2005

Working Paper No. 264
By Rodrigo Cifuentes, Gianluigi Ferrucci and Hyun Song Shin

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.

PDFLiquidity risk and contagion

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