Liquidity Risk and Contagion

TLDR

Liquidity risk in interconnected financial institutions, subject to solvency constraints and mark‑to‑market valuation, can trigger contagious failures when illiquid asset demand is inelastic, as distressed sales depress prices and induce further asset fire‑sales. The study investigates the theoretical basis for contagious failures and quantifies them through simulation exercises. The authors use simulation exercises to quantify contagious failures. Liquidity requirements on institutions can be as effective as capital requirements in forestalling contagious failures.

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.