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Woon Gyu Choi and Mr. David Cook
During periods of financial turmoil, increases in risk lead to higher default, foreclosure, and fire sales. This paper introduces a costly liquidation process for foreclosed collateral and endogenous recovery rates in a dynamic stochastic general equilibrium model of the financial accelerator. Consistent with empirical evidence, we find that recovery rates are pro-cyclical when collateral is costly to liquidate. Through links between recovery rates, risk premia, and default risk, the model generates an additional liquidity spiral, a feedback loop for the financial accelerator. We illustrate how collateral liquidation and monetary policy alter the impacts of a financial shock. We also show that a government subsidy on collateral liquidity and the endogenous accumulation of liquidity inventory help dampen the liquidity spiral by shoring up recovery rates.
Woon Gyu Choi and Mr. David Cook

in investment acts as a negative demand shock. The rise in firm-level productivity volatility exogenously increases the probability of default. As defaults become more common across firms, the illiquidity of foreclosed assets reduces recovery rates, which, in turn, raise the risk premium. The greater risk premium negatively affects the aggregate economy and thus raises the probability of default. Endogenous liquidity of foreclosed properties then acts as a feedback loop – a liquidity spiral –which amplifies the financial accelerator. Using a fairly standard DSGE

Mr. Daniel C Hardy and Philipp Hochreiter
A mechanism is proposed that aims to reduce the risk of a banking sector liquidity crisis—which is a quintessentially systemic event and thus the object of macroprudential policy—and moderate the effects of a crisis should one occur. The instrument would give banks more incentive to build up buffers of systemically liquid assets as a proportion of their total liabilities, yet these buffers would be usable in times of stress. The modalities of the instrument are considered with a view to making it effective, efficient, and robust.
Mr. Fei Han and Mindaugas Leika
The paper presents a framework to integrate liquidity and solvency stress tests. An empirical study based on European bond trading data finds that asset sales haircuts depend on the total amount of assets sold and general liquidity conditions in the market. To account for variations in market liquidity, the study uses Markov regime-switching models and links haircuts with market volatility and the amount of securities sold by banks. The framework is accompanied by a Matlab program and an Excel-based tool, which allow the calculations to be replicated for any type of traded security and to be used for liquidity and solvency stress testing.
International Monetary Fund. Monetary and Capital Markets Department

for the clarity of central bank communications when balancing their responsibilities for formulating monetary policy and protecting financial stability. This chapter examines recent events and makes some recommendations for the future. The concepts of market and funding liquidity that are relevant for understanding the episode are examined first, along with how banks have managed liquidity risks in recent months. The various ways in which market and funding liquidity can interact to cause self-sustaining “liquidity spirals” is then explained, including why such

Woon Gyu Choi and Mr. David Cook

Front Matter Page IMF Institute Authorized for distribution by Ling Hui Tan Contents I. Introduction II. The Model A. Competitive Firms B. Household C. Capitalists D. Retailers and Wholesalers E. Central Bank and Shocks F. Calibration G. Discussion: Financial Shocks and Liquidity Spirals III. Model Results A. Impacts of Financial Shocks and the Role of Collateral Liquidity B. Interest Rate Policy Response: Concerns about Recession Risk C. Government Subsidy for Collateral Liquidation D. Endogenous Accumulation of

Mr. Heiko Hesse, Nathaniel Frank, and Ms. Brenda Gonzalez-Hermosillo

throughout the banking sector, and as a result of which credit default swap (CDS) spreads increased significantly across the industry during the crisis. The transmission mechanisms of liquidity shocks across differing U.S. financial markets outlined so far have been described as being unidirectional and sequential. But during periods of financial stress, as witnessed during the subprime crisis, re-enforcing liquidity spirals may be observed. 4 As discussed above, market illiquidity can turn into funding illiquidity, as banks are forced to reabsorb their SIVs onto

Mr. Heiko Hesse, Nathaniel Frank, and Ms. Brenda Gonzalez-Hermosillo
We examine the linkages between market and funding liquidity pressures, as well as their interaction with solvency issues surrounding key financial institutions during the 2007 subprime crisis. A multivariate GARCH model is estimated in order to test for the transmission of liquidity shocks across U.S. financial markets. It is found that the interaction between market and funding illiquidity increases sharply during the recent period of financial turbulence, and that bank solvency becomes important.
Mr. Daniel C Hardy and Philipp Hochreiter

” such as leverage and “information amplifiers” grounded in financial agents’ imperfect knowledge regarding cross-exposures can propagate destabilizing “liquidity spirals” ( Krishnamurthy, 2009 ). Brunnermeier (2008) distinguishes between two separate yet intertwined “liquidity spirals” that may, especially against the backdrop of excessive leverage of financial agents, render a comparably small and isolated shock into a systemic liquidity crisis: On the one hand, a “loss spiral” may arise when a leveraged financial institution incurs a large enough loss on some of