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.

A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research

“…The writing-down of assets, due to mark-to-market accounting caused a tightening of capital adequacy requirements, forcing banks to securitize and sell their assets. Due to illiquidity in the market, such forced sales caused further deterioration in the values of these assets, which, in turn, caused additional write-downs and additional forced sales and so on (see Cifuentes, Ferrucci, and Shin [2005], Allen and Carletti [2008], Heaton, Lucas, and McDonald [2010]). Thus, it was alleged that mark-to-market accounting had procyclical properties and had entrapped banks in a self-confirming downward spiral.…”

Interbank Credit Lines as a Channel of Contagion

“…This paper focuses on financial contagion through linkages between banks. Contagion could, though, also be driven by information orVas analyzed by Cifuentes et al (2004)Vby the sale of illiquid assets by distressed banks to meet regulatory capital requirements. 1 Moreover, the failure of a large number of banks could as well be the result of a macroeconomic shock which affected institutions exposed to a common risk more or less simultaneously.…”

Liquidity Coinsurance, Moral Hazard, and Financial Contagion

“…However, these authors assume a fixed structure of interbank claims, and therefore fail to capture all of the ramifications of a bank failure. Cifuentes, Ferrucci, and Shin (2005) show that when prices are allowed to change endogenously, the impact of an initial shock may be considerable.…”