ECB study introduces method to detect financial liquidity spirals

A new European Central Bank working paper introduces a novel method for studying liquidity spirals and identifying them before financial markets are disrupted. The research highlights how interactions between contagion channels and institutions can lead to underestimation of risks.

Unveiling the robust-yet-fragile system

The study introduces a novel method using a 'shock transmission matrix' to detect liquidity spirals early, without relying on specific stress scenarios.

This matrix captures multiple interacting contagion channels and includes both banks and non-bank financial institutions (NBFIs).

A key insight is that institutions' asset liquidation strategies significantly impact system stability.

Selling highly liquid assets first can create a 'robust-yet-fragile' system, resilient to small shocks but highly vulnerable to larger ones when liquid assets are depleted.

This approach allows for the identification of spirals before market and funding liquidities actually fall, by tracking feedback effects within the system.

Targeted interventions for financial stability

Applying the model to the South African banking and investment fund sectors, the research reveals that liquidity spirals can stem from the collective dynamics of both sectors or be driven by a single sector under certain market conditions.

This granular analysis highlights that the risk of a spiral increases when institutions' most liquid assets are reduced.

Crucially, central bank liquidity injections can dampen spirals, but interventions must be carefully targeted.

Simply providing liquidity to one sector may be ineffective if another sector is the primary driver of the spiral.

The developed approach offers a tool for regulators to identify sector-specific vulnerabilities and design precise policy responses to maintain financial stability.