Systematic Liquidity Risk Research Articles

Bank’s strategic interaction, adverse price dynamics and systemic liquidity risk

AbstractWhen a widespread funding shock hits the banking system, banks may engage in strategic behaviour to deal with funding shortages by a pre-emptive disposal of assets. Alternatively, they may adopt a more cautious strategy to mitigate price reactions, thereby distributing the assets sales into smaller portions over time. We model banks’ optimal behaviour using standard optimisation techniques and show that an equilibrium always exits in a stylised setting. A numerical analysis to approximate the equilibrium supplements the theoretical part. The implementation delivers two liquidity measures for the German banking system: the Systemic Liquidity Buffer and the Systemic Liquidity Shortfall. These measures are more informative about systemic liquidity risk than regulatory liquidity measures, such as the LCR, because they model adverse, nonlinear price dynamics in a more realistic way. Our approach is applied to different stress scenarios.

Synthetic Central Bank Digital Currencies and Systemic Liquidity Risks

The failure of major banks in 2023, such as Silicon Valley Bank (SVB), Signature Bank, First Republic Bank, and Credit Suisse, points to the continuing need for financial institutions to price liquidity risk properly and for financial systems to find alternative sources of liquidity in times of dire need. Central bank digital currencies (CBDCs), fiat-backed stablecoins (fsCOINs), and synthetic central bank digital currencies (sCBDCs) could offer improvements, but each comes with its own set of problems and conditions. Prior research reaches conflicting conclusions about the effect that each of these three financial assets has on systemic bank liquidity and fails to adequately address their net benefits relative to each other. This paper addresses these issues, including those connected to financial disintermediation, bank runs, outsourcing central bank activities, financial interoperability, cash equivalents, maturity transformation, required reserves, and changes in nations’ monetary bases. After addressing the strengths and weaknesses of fsCOINs and CBDCs, we conclude that sCBDCs provide the most significant net liquidity benefits when risks and returns are considered.

Commonality in Liquidity: Evidence from Emerging Asian Actively-Managed Equity Funds

In this study, a set of common factors of liquidity that had previously been recorded at the equity security level is examined for its effect on inter and intra-market liquidity variations in equity funds in emerging Asian markets. Cross-market liquidity co-movement between the fund’s portfolio and the market portfolio, which typically measures systematic liquidity risk and market integration, is the liquidity commonality for mutual funds. This research builds on Wang Jianxin’s study in 2013 by including market liquidity, return and volatility as common factors of liquidity, and the partial R2 of the common factors reveals each factor’s contribution. We find that emerging Asian countries share 24.14% of the intra-market liquidity commonality between funds and equity markets, and market liquidity is tied to such relationship. Emerging Asian region share 2.76% of inter-market liquidity commonality and regional market return and volatility majorly contribute to this liquidity commonality. The significance of domestic financial markets is evidenced by the wide disparity in liquidity commonality between domestic and regional markets.

Liquidity Risk, Return Performance, and Tracking Error: Synthetic vs. Physical ETFs

As the global ETF market continues to grow, the significance of understanding replication strategies has become increasingly apparent. This study examines the compensation of synthetic exchange-traded funds (ETFs) due to their greater risk exposure than physical ETFs, using ETFs listed on developed European markets from 2009 to 2020. This is the first study to investigate liquidity risk related to the replication strategy of ETFs. We investigate the difference in systematic liquidity risk between synthetic and physical ETFs using a liquidity-adjusted capital asset pricing model (LCAPM). Our findings suggest that synthetic ETFs have higher liquidity risks than physical ETFs and offer additional returns within the low-liquidity group. We also analyze the tracking performance of ETFs based on their type and find that the synthetic replication method reduces tracking errors within the high-liquidity group. Specifically, the enhanced tracking performance of synthetic ETFs becomes more prominent during periods of liquidity shocks than in regular periods. These findings shed light on key considerations for resolving puzzles in tracking errors.

Управління ліквідністю банків на макро- та мікрорівнях

The article is aimed at deepening and systematizing the theoretical and methodological foundations of liquidity management at the macro and micro levels. The state of liquidity of the banking system of Ukraine during the war period is analyzed and the shortcomings of the practice of liquidity management of banks at the macro and micro levels are allocated. It is found that, despite a sufficient level of liquidity of domestic banks and moderate systemic liquidity risk, banks have problems with a fixed-term deposit structure, a significant liquidity surplus, increased funding costs and increased competition for business funds. The theoretical and methodological foundations of liquidity management at different levels are systematized and supplemented, taking into account the actual problems of liquidity management of domestic banks. Two structural and logical schemes of liquidity management of the bank at the micro and macro levels have been built, which contain conceptual foundations for building liquidity management (principles, methods, instruments, communication) and take into account modern regulatory requirements (central bank, Basel committee). At the micro level, the process of liquidity management and liquidity risk management is differentiated, taking into account the channels of interaction, specific methods and instruments. Methods and instrumentarium for liquidity risk management in the process of bank liquidity management have been expanded. A universal, step-by-step algorithm of liquidity management process at the micro level is proposed. The instrumentarium of liquidity monitoring at the bank level is systematized, taking into account modern practice. The conceptual foundations of liquidity management at the macro level have been supplemented, in particular: 1) management instruments have been supplemented by the indicative ones; 2) the principles have been expanded, synergy, behaviorality, controllability have been added; 3) the functions and objectives of management are adjusted taking into account crisis factors. Emphasis is placed on proper inter-level communication and coherence of strategies, policies, methodologies and procedures for managing liquidity of banks. It is determined that the regulator at the macro level should form an appropriate atmosphere for effective liquidity management at the micro level, and banks should take a responsible (taking into account system-wide goals) approach to the liquidity management. Prospects for further research in this direction are: 1) analysis of the impact of technological innovations on the process of liquidity management at the macro and micro levels; 2) study of the global context, namely the impact of systemic shocks of different jurisdictions on the liquidity of the domestic banking system.

Dividend policy, systematic liquidity risk, and the cost of equity capital

Dividend policy, systematic liquidity risk, and the cost of equity capital

Central Clearing and Systemic Liquidity Risk

By stepping between bilateral counterparties, central counterparties (CCPs) transform credit exposure, thereby improving financial stability. But, large CCPs are concentrated and interconnected with major global banks. Moreover, although they mitigate credit risk, CCPs create liquidity risks, because they require participants to provide cash. Such requirements increase with market volatility; consequently, CCP liquidity needs are inherently procyclical. This procyclicality makes it more challenging to assess CCPs’ resilience in the rare event that one or more large financial institutions default. Liquidity-focused macroprudential stress tests could help to assess and manage this systemic liquidity risk.

Banks' Strategic Interaction, Adverse Price Dynamics and Systemic Liquidity Risk

Banks' Strategic Interaction, Adverse Price Dynamics and Systemic Liquidity Risk

Systemic liquidity contagion in the European interbank market

Systemic liquidity risk, defined by the International Monetary Fund as “the risk of simultaneous liquidity difficulties at multiple financial institutions,” is a key topic in financial stability studies and macroprudential policy-making. In this context, the complex web of interconnections of the interbank market plays the crucial role of allowing funding liquidity shortages to propagate between financial institutions. Here, we introduce a simple yet effective model of the interbank market in which liquidity shortages propagate through an epidemic-like contagion mechanism on the network of interbank loans. The model is defined by using aggregate balance sheet information of European banks, and it exploits country and bank-specific risk features to account for the heterogeneity of financial institutions. Moreover, in order to obtain the European-wide topology of the interbank network, we define a block reconstruction method based on the exchange flows between the various countries. We show that the proposed contagion model is able to estimate systemic liquidity risk across different years and countries. Results suggest that our effective contagion approach can be successfully used as a viable alternative to more realistic but complicated models, which not only require more specific balance sheet variables with high time resolution but also need assumptions on how banks respond to liquidity shocks.

Systemic Illiquidity Noise-Based Measure—A Solution for Systemic Liquidity Monitoring in Frontier and Emerging Markets

The paper presents an alternative approach to measuring systemic illiquidity applicable to countries with frontier and emerging financial markets, where other existing methods are not applicable. We develop a novel Systemic Illiquidity Noise (SIN)-based measure, using the Nelson–Siegel–Svensson methodology in which we utilize the curve-fitting error as an indicator of financial system illiquidity. We empirically apply our method to a set of 10 divergent Central and Eastern Europe countries—Bulgaria, Croatia, Czechia, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Slovakia—in the period of 2006–2020. The results show three periods of increased risk in the sample period: the global financial crisis, the European public debt crisis, and the COVID-19 pandemic. They also allow us to identify three divergent sets of countries with different systemic liquidity risk characteristics. The analysis also illustrates the impact of the introduction of the euro on systemic illiquidity risk. The proposed methodology may be of consequence for financial system regulators and macroprudential bodies: it allows for contemporaneous monitoring of discussed risk at a minimal cost using well-known models and easily accessible data.

Money in the Equilibrium of Banking1

AbstractMoney is both the medium for transaction and the most liquid asset for banks. We examine both roles of money in an integrated framework, where banks are subject to aggregate illiquidity risk. An active central bank can replicate the constrained efficient allocation, which, however, cannot be implemented in the market equilibrium: due to moral hazard problems, banks invest excessively in illiquid assets, forcing the central bank to provide liquidity at low interest rates. An interest rate policy aiming to reduce systemic liquidity risk is dynamically inconsistent. Instead, the constrained efficiency can be achieved by imposing ex ante liquidity coverage requirement.

Can Market Structure Impact Systemic Risk? Evidence from Trade-Through Prohibition

We examine changes in systemic liquidity risk brought about by the trade-through prohibition and the fragmentation of order flow caused by Reg NMS. A dynamic factor model allows us to decompose liquidity co-variances into “exchange-specific” and “market-wide” components. We document a decrease in liquidity measures driven by exchange-specific factors, and an increase in the variance explained by market-wide factors following the implementation of Reg NMS. Overall commonality decreases, with liquidity shocks smoothed across multiple trading venues. While liquidity shocks are shared among more exchanges (becoming more systemic), the impact of a single shock on any individual exchange actually declines.

Could Etfs Make Stock Markets More Vulnerable to Systemic Liquidity Shock? – Evidence From Emerging Asia

Using a dataset on ETFs ownership of stocks in nine Emerging Asian markets, we find that stocks with a higher ETF ownership exhibit a greater commonality in liquidity to other stocks in the same market. The effect increases with the level of ETFs arbitrage activities, supporting the hypothesis that ETFs arbitrage mechanism is the source of commonality in liquidity. We also find that the effect is asymmetric; ETFs exert a stronger influence when stocks’ liquidity decline. These findings are supported by a cross-market analysis, as we show that the effect is larger in market where stocks have more common exposures to ETFs, while tightened capital market condition could also amplify the effect of ETF ownership. Increased financial market openness, on the other hand, may ease the potential systemic impact. ETFs ownership of stocks also increases the commonality in liquidity of stocks across markets. The cross-markets impacts by ETFs present a channel via which financial market integration through ETFs could lead to a build-up of systemic liquidity risks and increase the vulnerability of liquidity shock spill-over to stock markets.

Collateral Unchained: Rehypothecation networks, concentration and systemic effects

We study how the practice of collateral rehypothecation impacts the generation of liquidity and the emergence of systemic liquidity risk, and how both depend on the structure of the financial network. We build a basic model where banks interact via chains of “repo” contracts (i.e. repurchasing agreements) and use their proprietary collateral or re-use the collateral obtained by other banks via “reverse repos”. We then extend the model to allow banks to determine endogenously the optimal amount of collateral to rehypothecate, based on the equilibrium level of Value-at-Risk. In this framework, we first show how total collateral volume and its velocity are affected by characteristics of the network such as the length of rehypothecation chains and the existence of closed (i.e. cyclic) chains of contracts, the presence of sink nodes (wherein collateral remains trapped), the direction of collateral flows, and the density of the network. We then demonstrate that a trade-off between liquidity and systemic risk exists for certain classes of networks structures. On the one hand, we show that structures where collateral flows are concentrated among fewer densely connected nodes allow for larger collateral volumes, even at low levels of network density. On the other hand, the same networks are also more exposed to larger cascades of collateral hoarding, as a result of localized liquidity shocks.

Commonality in FX liquidity: High-frequency evidence

We test the existence and reveal the main properties of commonality in liquidity for the foreign exchange (FX) markets at the high-frequency level. Accordingly, commonality in FX liquidity exists even at the high-frequency level and it has been gradually increasing over the last few years. Moreover, commonality increases significantly before (after) ECB (Fed) monetary policy announcements. Finally, commonality in FX liquidity has a significant positive impact on the commonality in FX return series, indicating that an increase in the intraday systematic liquidity risk might trigger a negative aggregate liquidity-return spiral in the FX markets.

Analyzing the Nonlinear Pricing of Liquidity Risk according to the Market State

This study examines the asymmetric impact of systemic liquidity on asset prices across market states. We use time-series conditional quantile regressions to estimate an otherwise traditional liquidity-augmented three-factor model for asset prices. We find the exposure of equity returns to systemic liquidity risk to be dependent on the market state. Contrary to general assumptions, our results show that liquidity is not always a relevant factor for explaining stock market returns and that it only becomes relevant when the market state is particularly good or particularly bad. Search-for-yield and flight-to-liquidity considerations help to explain our findings.

Commonality in FX Liquidity: High-Frequency Evidence

We test the existence and reveal the main properties of commonality in liquidity for the foreign exchange (FX) markets at the high-frequency level. Accordingly, commonality in FX liquidity exists even at the high-frequency level and it has been gradually increasing over the last few years. Unlike ECB, monetary policy announcement made by Fed significantly increases this commonality. Moreover, commonality in FX liquidity has a significant positive impact on the commonality in FX return series, indicating that an increase in the intraday systematic liquidity risk might trigger a negative aggregate liquidity-return spiral in the FX markets.

Central Clearing and Systemic Liquidity Risk

By stepping between bilateral counterparties, a central counterparty (CCP) transforms credit exposure. CCPs generally improve financial stability. Nevertheless, large CCPs are by nature concentrated and interconnected with major global banks. Moreover, although they mitigate credit risk, CCPs create liquidity risks, because they rely on participants to provide cash. Such requirements increase with both market volatility and default; consequently, CCP liquidity needs are inherently procyclical. This procyclicality makes it more challenging to assess CCP resilience in the rare event that one or more large financial institutions default. Liquidity-focused macroprudential stress tests could help to assess and manage this systemic liquidity risk.

Liquidity commonality and high frequency trading: Evidence from the French stock market

High frequency trading (HFT) depends on sophisticated algorithms to closely monitor price changes across securities. Theory predicts this technological advantage should translate into market-wide liquidity co-variation, by transmitting information-based liquidity shocks. Using a dataset of orders and trades from the French stock market, we investigate whether HFT algorithms constitute a source of systematic liquidity risk. We demonstrate that, across securities, the liquidity offered by high frequency traders is significantly less diverse than that of traditional traders; this finding is in line with the cross-asset learning hypothesis. The excessive co-movement in liquidity is also partly explained by common market making rules. In periods of increased market stress, we find HFT, designated market making, and order size to be important sources of liquidity commonality. Our results have policy implications for market regulators in Paris, suggesting the inclusion of maximum spread-limit rules in market making contracts will reduce the possibility of liquidity drying up when markets are in turmoil.

THE PREVENTION OF SYSTEMIC LIQUIDITY RISK IN MODERN CONDITIONS OF BANKING REGULATION

The urgency and danger of systemic risks of the banking sector are highlighted. The features to the interpretation of the concept of systemic risk from both the position of scientists and through the prism of international organizations dealing with issues of regulation of financial markets are determined. There are three main approaches to understanding: microeconomic, macroeconomic and integrated are written. The concept of systemic liquidity risk, features of it’s distribution and necessity of regulation are disclosed. The methods of measuring the systemic liquidity risk in accordance with international practice are indicated and the main parameters of its estimation in the domestic banking sector are presented. Complex analysis of the banking system of Ukraine was conducted to identify a systemic liquidity risk or finding the possibility of developing it, and draw some conclusions. The necessity of strengthening control over systemically important banking institutions is mentioned. The prospects for improving the regulation of systemic liquidity risk for the Ukrainian banking market are proposed.