The system switches to a low-liquidity equilibrium. These liquidity droughts were perhaps the defining feature of the financial crisis during 2007 and 2008. In the model, the likelihood of such systemic liquidity crises depends critically on two key structural characteristics of the financial system – the two c’s: concentration and complexity. The greater the concentration within the financial system, the greater the potential for systemic collapse as larger banks spread a disproportionate amount of financial pain around a densely networked financial system. A greater degree of system complexity has a similar effect, creating more channels for contagion and heightening banks’ incentives to hoard liquidity when the weather worsens. The two c’s are very much features of today’s financial system. On the face of it, that bodes ill for future systemic crises. So what role might policy play in avoiding those crises? The model provides a test-bed to consider a range of policy options, including for haircuts policy. An illustrative policy experiment, based on a simulation of the model in which haircuts spike sharply, is shown in Chart 1. Up the vertical axis is a measure of the probability of a systemic liquidity crisis. Along the horizontal axis is the initial size of the haircut on secured financing transactions. The three lines trace three policy options. Consider first the “baseline” path without policy intervention. Provided haircuts remain high come rain or shine – in the example, above around 20% – the probability of a liquidity crisis remains very low.

A recent paper, co-authored with Prasanna Gai and Sujit Kapadia, attempts to fill that gap.4 We  1  For example, Committee on the Global Financial System (2010), “The role of margin requirements and haircuts in procyclicality”, CGFS Publications No. 36, Geanakoplos, J (2010), “Solving the present crisis and managing the leverage cycle”, Federal Reserve Bank of New York Economic Policy Review, August, 16 (1) and Kashyap, A K, Berner, R and Goodhart, C, “The Macroprudential Toolkit”, forthcoming in the IMF Economic Review. 2  http://www.hm-treasury.gov.uk/d/consult_newfinancial_regulation170211.pdf. 3  http://www.treasury.gov/press-center/press-releases/Pages/tg1202.aspx. 4  “Complexity, Concentration and Contagion”, which is forthcoming in the Journal of Monetary Economics, Vol 58 (5). 2  BIS central bankers’ speeches  develop a model of a banking network, inter-connected through unsecured interbank lending and secured funding markets. This financial web exhibits classical tipping point properties. It is even-tempered most of the time. Indeed, having a tight-knit circle of financial friends helps keep the financial system strong and stable. Risks are diffused across the system. A problem shared is a problem halved. The system is in a high-liquidity equilibrium. But, on occasion, the system can be pushed beyond its tipping point. Connectivity then generates contagion. A problem shared is a problem multiplied. The best of financial friends become the worst of enemies. In the model, one of the key channels for contagion is the secured financing market as banks hoard rather than lend liquidity when haircuts rise. The liquidity feast then turns to famine as secured and unsecured financing markets dry up.