Margin requirements and systemic liquidity risk

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.