Liquidity Risk and Contagion
Abstract (Via Bank Of England)
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.
Introduction (Via Bank Of England)
Prudential regulations in the form of liquidity or capital requirements are designed to enhance the resilience of financial systems under a broad range of market conditions. However, at times of market turbulence the remedial actions prescribed by these regulations may have perverse effects on systemic stability. Forced sales of assets may feed back on market volatility and produce a downward spiral in asset prices, which in turn may affect adversely other financial institutions. Regulators are familiar with the potentially destabilizing effects of solvency constraints in distressed markets. For example, in the wake of the September 11th attacks in the United States, global financial markets were buffeted by unprecedented turbulence, which prompted the authorities to suspend various solvency tests applied to large financial institutions. In the United Kingdom, for instance, the ’resilience test’ applied to life insurers (in which firms have to demonstrate solvency in the face of a 25% market decline) was suspended for several weeks. Also, following the decline in the European stock markets in the summer of 2002, the Financial Services Authority – the UK regulator – diluted the resilience test so as to preempt the destabilizing forced sales of stocks by the major market players. The crisis of the Long-Term Capital Management (LTCM) hedge fund in 1998 is another instance where credit links and asset prices acted in concert to propagate market distress.
This paper looks at these issues. It combines liquidity risk with externally imposed regulatory solvency requirements, when mark-to-market accounting rules of firms’ assets are in place. The model incorporates two channels of contagion direct balance sheet interconnections among financial institutions and contagion via changes in asset prices. Changes in asset prices may interact with externally imposed solvency requirements or the internal risk controls of financial institutions to generate amplified endogenous responses that are disproportionately large relative to any initial shock. A shock that reduces the market value of a firm’s balance sheet elicits the disposal of assets or of trading positions. If the market’s demand is less than perfectly elastic, such disposals result in a short run change in market prices. When assets are marked to market at the new prices, the externally imposed solvency constraints, or the internally imposed risk controls may dictate further disposals. In turn, such disposals will have a further impact on market prices. In this way, the combination of mark-to-market accounting and solvency constraints has the potential to induce an endogenous response that far outweighs the initial shock.