Liquidity Risk, Cash Flow Constraints, and Systemic Feedbacks
This chapter develops a quantitative framework which shows how shocks to fundamentals may interact with funding liquidity risk and potentially generate contagion that can spread across the financial system. First, it introduces a "danger zone" approach to model how shocks affect individual banks' funding liquidity risk. Second, the chapter combines the danger zone approach with simple behavioral reactions to assess how liquidity crises can spread through the system. Last, using the RAMSI (Risk Assessment Model for Systemic Institutions) stress-testing model, it generates illustrative distributions for bank profitability to show how funding liquidity risk and associated contagion may exacerbate overall systemic risk and amplify distress during financial crises.
This research was undertaken when John Elliott, Sujit Kapadia and Gabriel Sterne all worked at the Bank of England, and when Mathias Drehmann worked at the Bank of England and the Bank for International Settlements. The views expressed in this paper are those of the authors, and not necessarily those of the Bank of England, Financial Policy Committee members, or the Bank for International Settlements.
This research was undertaken, when Mathias worked for the Bank of England and the BIS.Gabriel Sterne
Funded by the Bank of England, all work on this research was undertaken while I was at the Bank of England. I acknowledge the advice and support of many colleagues in the Bank of England and from the academic and central banking community more broadly.