Liquidity Risk, Cash Flow Constraints, and Systemic Feedbacks

This chapter develops a quantitative framework which shows how shocks to fundamentals may interact with funding liquidity risk and potentially generate contagion that can spread across the financial system. First, it introduces a "danger zone" approach to model how shocks affect individual banks' funding liquidity risk. Second, the chapter combines the danger zone approach with simple behavioral reactions to assess how liquidity crises can spread through the system. Last, using the RAMSI (Risk Assessment Model for Systemic Institutions) stress-testing model, it generates illustrative distributions for bank profitability to show how funding liquidity risk and associated contagion may exacerbate overall systemic risk and amplify distress during financial crises.