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.
Citation:
Wiersema, G., Kemp, E. &Farmer, J.D. (2023). 'Liquidity Spirals'. INET Oxford Working Paper No. 2023-16.