On liquidity

Bank liquidity and economic activity

In this paper, Iyer et al. investigate the relationship between bank liquidity and local economic activity. The authors find that an increase in deposit rates offered by banks within a geographic region is associated with contractions in economic activity. This increase in deposit rates reflects the liquidity squeeze experienced by banks due to deteriorating economic conditions. The intuition behind this idea is that a contraction in regional economic activity leads corporate profits and household incomes to decline impacting the deposit growth of banks operating within the region, and exerting pressure on the liability side of their balance sheet.

• If banks expect the economic shocks to be short-lived, they are likely to use short-term funding in response to these transitory liquidity shocks.
• If banks anticipate a more persistent economic decline, they may increase their deposit rates to attract additional deposits to manage their liquidity shortages.

Their dataset includes deposit rates for 12-month certificates of deposit ($10K 12-month CDs) with a minimum account size of $10,000 offered by 8,361 distinct banks in 2,897 U.S. distinct counties for the period from 2001 through 2020. The authors present a novel real-time measure for assessing the build-up of regional economic and financial risks, using spatial variation in bank liquidity changes. The findings reveal that an increase in deposit rates at the county level serves as an early indicator of changes in economic activity across various dimensions such as lower GDP growth, reduced business formation, and higher loan delinquencies. These findings have implications for both macro- and micro-prudential policy, as real-time measurement of these risks is essential for policy-making. The authors acknowledge the support and feedback of various individuals and institutions in conducting this research.

Canary in the Coal Mine: Bank Liquidity Shortages and Local Economic Activity
Authors: Rajkamal Iyer, Shohini Kundu, Nikos Paltalidis
From: Imperial College, UCLA, Durham University Business School

Liquidity spirals

In this paper, Wiersema et al. provide a comprehensive analysis of liquidity spirals and their implications for financial stability, using a unique method to study the interconnectedness of contagion channels and the impact of institutions’ choices on the emergence of liquidity spirals. They introduce a novel method for studying liquidity spirals and their impact on financial stability that allows for the identification of such spirals before stock prices plummet and funding markets lock up. The authors demonstrate that liquidity spirals may be underestimated or completely overlooked when interactions between contagion channels are ignored. When the method is applied to a highly granular data set on the South African banking sector and investment fund sector, they find that liquidity spirals are exacerbated when the liquidity positions of institutions worsen, and that central bank-provided liquidity can greatly dampen liquidity spirals.

[A] liquidity spiral may emerge as soon as a substantial part of institutions’ pecking orders are exhausted by a sizable liquidity shock. This robust-yet-fragile tendency may appear in any financial system where institutions liquidate assets in order of decreasing liquidity, as contagion typically worsens as institutions are forced to liquidate assets of lesser and lesser liquidity. This highlights the importance of exploring financial stability across all layers of institutions’ pecking orders.

Liquidity Spirals
Authors: Garbrand Wiersema, Esti Kemp, J. Doyne Farmer
From: University of Oxford