Liquidity spirals

Garbrand Wiersema, Esti Kemp and J. Doyne Farmer

No 3169, Working Paper Series from European Central Bank

Abstract: The financial crisis of 2007-2008 highlighted the risks that liquidity spirals pose to financial stability. We introduce a novel method for studying liquidity spirals and use this method to identify spirals before stock prices plummet and funding markets lock up. We show that liquidity spirals may be underestimated or completely overlooked when interactions between different types of contagion channels or institutions are ignored. We also find that financial stability is greatly affected by how institutions choose to respond to liquidity shocks, with some strategies yielding a “robust-yet-fragile" system. To demonstrate the method, we apply it to a highly granular data set on the South African banking sector and investment fund sector. We find that the risk of a liquidity spiral emerging increases when the pool of institutions' most liquid assets is reduced, while a liquidity injection by the central bank can dampen the spiral. We further show that a liquidity spiral may be due to the banking and fund sectors' collective dynamics, but can also be driven by an individual sector under some market conditions. The approach developed here canbe used to formulate interventions that specifically target the sector(s) causing the liquidity spiral. JEL Classification: G01, G17, G21, G23, G28

Keywords: financial contagion; liquidity risk; non-banks financial institutions (NBFIs); system-wide stress test; systemic risk (search for similar items in EconPapers)
Date: 2026-01
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20263169

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