ECB research unveils novel method for identifying financial liquidity spirals
A new European Central Bank working paper introduces a novel method for studying liquidity spirals, which pose significant risks to financial stability. The research highlights how these spirals can be underestimated and how institutional responses to liquidity shocks impact system stability.
Detecting hidden liquidity spirals early
The study introduces a new method to detect liquidity spirals early, before they lead to severe financial market disruptions.
This approach uses a shock transmission matrix to identify when feedback effects become strong enough to trigger a spiral, capturing multiple interacting contagion channels and both banks and non-bank financial institutions.
A key insight is that institutions' asset selling strategies in response to shocks critically influence system stability, potentially creating a "robust-yet-fragile" system that is resilient to small shocks but vulnerable to larger ones.
South African insights, global lessons
Applied to the South African financial system, the model shows that liquidity spiral risk rises when institutions' most liquid assets decrease, and central bank liquidity injections can dampen these spirals.
The study found spirals can stem from collective banking and fund sector dynamics or be driven by a single sector.
This implies that policy interventions, such as central bank liquidity support, require careful targeting to the specific sector(s) causing the spiral for effective financial stability.