Liquidity Spirals and Financial Stability Analysis

This working paper discusses the concept of liquidity spirals and their implications for financial stability, particularly in the context of the 2007-2008 financial crisis. It introduces a novel method for detecting liquidity spirals before they lead to severe market disruptions. The authors emphasize the importance of understanding the interactions between different contagion channels, which include banks and non-bank financial institutions (NBFIs). The study employs a shock transmission matrix to identify when liquidity spirals begin to develop, highlighting that feedback effects within the financial system can trigger these spirals. The research uses a granular dataset from the South African banking and investment fund sectors to demonstrate the method's applicability. It finds that liquidity spirals can emerge from the collective dynamics of these sectors or be driven by individual sector instability. The paper concludes by discussing the policy implications of these findings, particularly the need for targeted interventions to maintain financial stability.