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The IUP Journal of Financial Risk Management
Systemic Liquidity Risk: A Macroeconomic Evaluation†
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The likelihood of not getting the desired funding at an appropriate cost or the probability of bearing an undue loss of value in a fire sale is recognized as liquidity risk. However, a flat idiosyncratic liquidity risk does not necessarily translate into a similar risk-neutral position at the systemic level. Systemic liquidity risk emanates from the underestimation and imprecise understanding of the liquidity conundrum and its causal relationship with the exogenous or endogenous factors. Systemic risk finally devolves at the macro level with serious repercussions. The present paper attempts a macroeconomic evaluation of the systemic liquidity risk from the perspective of developing economies. As a test case, the relevant macroeconomic data from the Indian financial system has been used for the purpose of analysis, modeling and interpretation.

 
 
 

Systemic liquidity risk has attracted the attention of the financial sector beyond the corridors of central banking, especially in the aftermath of the global financial crisis. However, it has not gained as much significance in the spectrum of risk management as it should have, given the enormity of its impact, and it has continued to be seen as a monetary policy or lender of last resort (LOLR) function. The challenge posed by the systemic liquidity risk is that even perfectly rational liquidity management decisions taken at the level of an individual financial institution could prove hazardous at the systemic level. Hence, it is important to understand the causal relationships between the macroeconomic variables impinging upon the systemic liquidity. There is an ongoing debate on how to adequately address the systemic component of the liquidity risk and a number of researchers have studied its various dimensions. Maddaloni (2015) noted that risk stemming from the bank’s liquidity management inefficiency or strategic liquidity management decisions has a bearing on the systemic level. Ratnovski and Huang (2009) examined the factors shaping the resilience of Canadian banks and noted that less reliance on wholesale funding than their peers in other advanced countries helped them. Demirguc and Huizinga (2009) found that the banks’ reliance on non-deposit sources of funds made them more vulnerable. Rajan (2006) observed that banks’ greater reliance on market liquidity caused risk to their balance sheets in times of crisis.

Most of the studies so far have primarily focused on the institution-specific factors for explaining the liquidity conundrum. However, a causal relationship so as to understand the manifestation of systemic liquidity risk has not been examined possibly with reference to the macroeconomic data of endogenous and exogenous factors in the context of a developing economy. While at the idiosyncratic level a number of factors could be responsible for a bank’s specific liquidity crunch, it is far more important and useful to understand the manifestation of the liquidity risk at the systemic level as a result of interaction of individual liquidity risk components. Second, the significance of price stability, ceteris paribus, for the systemic liquidity in the context of developing economies has not been fully explored. Third, the question relating to the asymmetric movement of systemic liquidity is very interesting and important from the policy perspective. The question as to whether the systemic liquidity risk is more pronounced in recessionary conditions or during inflationary phase needs empirical evaluation to examine a possibility for the existence of a zone of stability. This study intends to examine the above three questions and find possible explanations in terms of a simple yet robust macroeconomic model of systemic liquidity which could work quite smoothly with minimal complexity and a high degree of significance.

 
 
 

Financial Risk Management Journal,Systemic Liquidity, Macroeconomic Model Estimation, Purpose of analysis, Modeling and interpretation.