European Central Bank publishes working paper on scenario-free early detection of liquidity spirals across banks and investment funds

The European Central Bank published a Working Paper (No 3169) presenting a scenario-free method to detect emerging liquidity spirals before sharp price declines and funding-market disruptions materialise. The staff research, which does not represent ECB views, uses a shock transmission matrix spanning multiple contagion channels and both banks and non-bank financial institutions (NBFIs), with a spiral indicated when the matrix’s dominant eigenvalue exceeds one. The paper finds that liquidity-spiral risk can be underestimated or missed entirely when interactions across contagion channels or across sectors are ignored. It also highlights that institutions’ asset liquidation strategies and “pecking orders” materially shape system stability, including a “robust-yet-fragile” configuration where selling the most liquid assets first contains small shocks but can amplify larger shocks once liquid buffers are exhausted. Applying the framework to granular data for South Africa’s banking and investment fund sectors, the authors report higher spiral risk when the pool of most liquid assets is reduced, and show that central bank liquidity injections can dampen spirals but may need to be targeted to the sector driving the feedback dynamics. The framework is positioned as a tool for system-wide stress testing and for designing sector-specific interventions, and is presented as applicable to other financial systems where sufficiently granular exposure and portfolio data are available.