Systemic Liquidity Crisis in a Banking System with Dynamic Haircuts

Abstract

In this paper, using network tools, I analyse systemic impacts of liquidity shocks in interbank market in case of endogenous haircuts. Gai, Haldane and Kapadia (2011) introduce a benchmark for liquidity crisis following haircut shocks, and Gorton and Metrick (2010) reveal the evidence from 2007-09 crisis for increasing haircuts with banking panic. In the benchmark model, I endogenize and update haircuts dynamically during the period of stress. The results significantly differ from static haircut case. I show that the gap in the impacts of haircut shocks between dynamic and static haircuts is persistent for different experiments. I analyse the effects of connectivity, balance sheet and network positions of banks, and liquidity level and distribution on crisis. As well as aggregate and idiosyncratic shocks, by considering possible correlations on the asset sides of banks, I also introduce a shock hitting several banks at the same time. This study may be useful for policy makers to predict the consequences of liquidity shocks more accurately. The findings are also related to microprudential regulation on liquidity surcharge for systemically important financial institutions (SIFI’s) and produce policy recommendations on minimum liquidity requirements.