A recent working paper from the Federal Reserve Bank of Boston examines how liquidity risks can propagate through networks of financial institutions, particularly during times of crisis. The study, coauthored by Lina Lu, a senior financial economist at the Boston Fed, and published by the Bank’s Supervisory Research and Analysis group, focuses on the impact of liquidity shocks within interconnected banks.
“In this analysis, we see that it’s critical to take into account how one bank’s liquidity risks can spill over and impact other banks’ liquidity risks in the future,” Lu stated. “Otherwise, we may be underestimating how much a shock is affecting an entire network of banks, and that could potentially compromise the stability of the financial system.”
The paper titled “Scenario-based Quantile Connectedness of the U.S. Interbank Liquidity Risk Network” includes contributions from Tomohiro Ando of Melbourne Business School, Jushan Bai from Columbia University, and Cindy Vojtech from the Federal Reserve Board of Governors.
The researchers analyzed data from 12 domestic and foreign banks designated as “global systemically important banks” before and during the COVID-19 pandemic. They found that liquidity shocks had stronger spillover effects among these institutions during the pandemic compared to pre-pandemic periods. According to Lu, when a bank faces an unexpected shortfall in liquidity, its actions to mitigate this—such as competing for deposits or selling investments—can affect other banks within its network.
The study utilized data on each bank's "liquidity coverage ratio," which measures high-quality liquid assets against estimated 30-day net cash outflows. This ratio indicates a bank's ability to meet short-term cash demands using high-quality liquid assets.
By developing a model to measure future liquidity risk distribution, the researchers assessed how current shocks to one bank's liquidity position could influence another bank's future liquidity risk. They focused on "idiosyncratic shocks"—those directly impacting one institution—and evaluated their transmission across interconnected banks before and during the pandemic.
“If there is a strong connection between two banks, then any shocks affecting one bank today can have a large effect on the other’s liquidity risk in the future,” Lu explained.
The findings indicate that interbank connections transmitting risks were more robust during the pandemic than prior. “Overall, the level of bank vulnerability to other banks’ liquidity shocks is higher during the pandemic than pre-pandemic,” noted Lu and her colleagues.
The researchers suggest that understanding these dynamics can aid regulators in identifying vulnerable or systemically important banks within networks for better financial stability monitoring.
“Most studies in this area look at liquidity risk under normal conditions, but it is also important to examine liquidity risks during periods of severe stress,” said Lu. “Networks can act very differently during a crisis period, so we should take that into account."
Further details are available in their working paper on bostonfed.org.
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