Domino Effects When Banks Hoard Liquidity: The French Network.

Summary We investigate the consequences of banks' liquidity hoarding behaviour for the stability of the financial system by proposing a new model of banking contagion through two channels, bilateral exposures and funding shortage. Inspired by the key role of liquidity hoarding in the 2007-2009 financial crisis, we incorporate banks' hoarding behaviour in a standard Iterative Default Cascade algorithm to compute the propagation of a common market shock through a banking system. In addition to potential solvency contagion, a market shock leads to banks liquidity hoarding that may generate problems of short-term funding for other banks. As an empirical exercise, we apply this model to the French banking system. Relying on data on banks bilateral exposures collected by France' Prudential Supervisory Authority, the French banking sector appears resilient to the combination of an initial market shock (losses on marked-to-market assets) and the resulting solvency and liquidity contagion. Moreover, the model gauges the relative weight of the various factors in the total loss.