Early warning signals and systems for liquidity risk

Abstract

Liquidity crises are initiated by a shock to the financial system that creates a vicious cycle of forced selling. The Basel Committee has proposed methods designed to prevent future liquidity crises and the International Monetary Fund has proposed methods, including the systemic liquidity risk index (SLRI), for measuring overall and bank-specific systemic risk. These methods are discussed with a focus on their advantages and limitations. In addition, an index for market liquidity, the CLX, is introduced, which is composed of inputs from five liquid derivatives contracts spanning equity, debt, rates and volatility markets. The CLX is shown to be useful for measuring various aspects of economic activity and to be highly correlated with the IMF's SLRI. In addition, the CLX forms the basis for a liquidity early warning system and can anticipate changes in several major economic releases.