Liquidity Spirals

J. Farmer, Garbrand Wiersema and Esti Kemp

INET Oxford Working Papers from Institute for New Economic Thinking at the Oxford Martin School, University of Oxford

Abstract: We introduce a novel method for studying liquidity spirals and use this method to identify spirals before stock prices plummet and funding markets lock up. We show that liquidity spirals may be underestimated or completely overlooked when interactions between contagion channels are ignored, and find that financial stability is greatly affected by how institutions choose to respond to liquidity shocks, with some strategies yielding a \robust-yet-fragile" system. To demonstrate the method, we apply it to a highly granular data set on the South African banking sector and investment fund sector. We find that liquidity spirals are exacerbated when the liquidity positions of institutions worsen, and that central bank-provided liquidity can greatly dampen liquidity spirals. We also show that, depending on the market conditions, a liquidity spirals is sometimes caused by the banking and fund sectors' collective dynamics, but at other times by one sector's individual impact. The approach developed here can be used to formulate interventions that specifically target the sector(s) causing the liquidity spiral.

Keywords: Liquidity Spiral; Financial Stability; Systemic Risk; Financial Contagion; Interacting Contagion Channels; Intersectoral Contagion Channels; Multiplex Networks; Stress Test; Solvency-Liquidity Nexus (search for similar items in EconPapers)
JEL-codes: G01 G17 G18 G21 G23 G28 (search for similar items in EconPapers)
Pages: 43 pages
Date: 2023-09
New Economics Papers: this item is included in nep-ban, nep-hme and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:amz:wpaper:2023-16

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