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A Market Risk Approach to Liquidity Risk and Financial Contagion

Author

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  • Dairo Estrada
  • Daniel Osorio
Abstract
According to traditional literature, liquidity risk in individual banks can turn into a system-wide ¯nancial crisis when either interbank credit exposures or bank runs are present. This paper shows that this phenomenon can also arise when individual liquidity risk trans- forms into system-wide market risk (even in the absence of bank runs and interbank credit networks). This happens when banks try to sell some portion of its assets in order to overcome a liquidity shortage (individual liquidity risk). These sales depress the market price of assets if demand is not perfectly elastic. Given the fact that banks mark to market the asset book, the fall of market price reduces the value of assets of every bank in the system (system-wide market risk), leaving them less suited for future liquidity shortages and therefore more prone to bankruptcies. The paper rationalizes this idea through the simulation of a model that tries to capture the behavior of a liq- uidity manager that faces shocks on bank deposits and loans. The main results suggest that the extent of ¯nancial contagion depends crucially on the size of the market for assets.

Suggested Citation

  • Dairo Estrada & Daniel Osorio, 2006. "A Market Risk Approach to Liquidity Risk and Financial Contagion," Borradores de Economia 384, Banco de la Republica de Colombia.
    • Handle: RePEc:bdr:borrec:384
    DOI: 10.32468/be.384
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    Cited by:

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    2. Wilmar Cabrera & Adriana María Corredor-Waldron & Carlos Quicazán, 2012. "Requerimientos Macroprudenciales de capital y riesgo sistémico: Una aplicación para Colombia," Temas de Estabilidad Financiera 074, Banco de la Republica de Colombia.
    3. Orlando Rivera-Escobar & John Willmer Escobar & Diego Fernando Manotas, 2022. "Measurement of Systemic Risk in the Colombian Banking Sector," Risks, MDPI, vol. 10(1), pages 1-27, January.

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    More about this item

    Keywords

    liquidity manager; liquidity risk; market risk; systemic risk; financial contagion; mark-to-market;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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