Margin requirements and systemic liquidity risk

Bakoush, Mohamed, Gerding, Enrico and Wolfe, Simon (2019) Margin requirements and systemic liquidity risk. Journal of International Financial Markets, Institutions and Money, 58, 78-95. (doi:10.1016/j.intfin.2018.09.007).

Record type: Article

Abstract

We develop a model in which margin procyclicality and the propensity for liquidity hoarding interact to generate a systemic liquidity crisis. In this model, banks lend and borrow in the interbank market to mitigate liquidity risk and trade derivatives contracts in the OTC derivatives market to mitigate market risk. The daily mark-to-market of derivatives
contracts results in daily margin calls that banks cover using high quality liquid assets. We
find that distress due to margin procyclicality in the derivatives market can spillover to the
interbank market leading to systemic liquidity risk. Interconnectedness further amplifies the
effects of systemic risk within the interbank market. The model shows that central clearing
might increase the possibility of systemic liquidity risk due to tight margin requirements
and the timing of cash flows required from banks. We also find that haircut levels affect the
possibility of systemic liquidity risk, and highlight the potential role of a market maker of
last resort in limiting this possibility

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