LIQUIDITY RISK AND CONTAGION | Zendy

Cifuentes Rodrigo | Zendy; Ferrucci Gianluigi | Zendy; Shin Hyun Song | Zendy

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LIQUIDITY RISK AND CONTAGION

Author(s) -

Cifuentes Rodrigo,

Ferrucci Gianluigi,

Shin Hyun Song

Publication year - 2005

Publication title -

journal of the european economic association

Language(s) - English

Resource type - Journals

SCImago Journal Rank - 7.792

H-Index - 93

eISSN - 1542-4774

pISSN - 1542-4766

DOI - 10.1162/jeea.2005.3.2-3.556

Subject(s) - market liquidity , economics , monetary economics , financial contagion , liquidity risk , business , financial system , financial crisis , macroeconomics

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. (JEL: G21, G28)

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