Market liquidity in the financial crisis: The role of liquidity commonality and flight-to-quality

We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.     

Understanding commonality in liquidity around the world

We examine how commonality in liquidity varies across countries and over time in ways related to supply determinants (funding liquidity of financial intermediaries) and demand determinants (correlated trading behavior of international and institutional investors, incentives to trade individual securities, and investor sentiment) of liquidity. Commonality in liquidity is greater in countries with and during times of high market volatility (especially, large market declines), greater presence of international investors, and more correlated trading activity. Our evidence is more reliably consistent with demand-side explanations and challenges the ability of the funding liquidity hypothesis to help us understand important aspects of financial market liquidity around the world, even during the recent financial crisis.     

Corporate bond liquidity before and after the onset of the subprime crisis

We analyze liquidity components of corporate bond spreads during 2005-2009 using a new robust illiquidity measure. The spread contribution from illiquidity increases dramatically with the onset of the subprime crisis. The increase is slow and persistent for investment grade bonds while the effect is stronger but more short-lived for speculative grade bonds. Bonds become less liquid when financial distress hits a lead underwriter and the liquidity of bonds issued by financial firms dries up under crises. During the subprime crisis, flight-to-quality is confined to AAA-rated bonds.     

Large EU banks’ capital and liquidity: Relationship and impact on credit default swap spreads

This paper explores the interrelations between bank capital and liquidity and their impact on the market probability of default. We employ an unbalanced panel of large European banks with listed credit default swap (CDS) contracts during the period 2005–2015, which allow us to consider the impact of the recent financial crisis. Our evidence suggests that bank capital and funding liquidity risk as defined in Basel III have an economically meaningful bidirectional relationship. However, the effect on CDS spread is ambiguous. While capital appears to have a relatively large impact on CDS spread changes, liquidity risk is priced only when it falls below the regulatory threshold.     

Reprint of: Market liquidity in the financial crisis: The role of liquidity commonality and flight-to-quality

We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.     

Foreign institutional ownership and stock market liquidity: Evidence from Indonesia

From January 2002 to August 2007, foreign institutions held almost 70% of the free-float value of the Indonesian equity market, or 41% of the total market capitalization. Over the same period, liquidity on the Jakarta Stock Exchange improved substantially with the average bid–ask spread more than halved and the average depth more than doubled. In this study we examine the Granger causality between foreign institutional ownership and liquidity, while controlling for persistence in foreign ownership and liquidity measures. We find that foreign holdings have a negative impact on future liquidity: a 10% increase in foreign institutional ownership in the current month is associated with approximately 2% increase in the bid–ask spread, 3% decrease in depth, and 4% rise in price sensitivity in the next month, challenging the view that foreign institutions enhance liquidity in small emerging markets. Our findings are consistent with the negative liquidity impact of institutional investor ownership in developed markets.     

The divergence of liquidity commonality in the cross-section of stocks

This paper demonstrates that the cross-sectional variation of liquidity commonality has increased over the period 1963–2005. The divergence of systematic liquidity can be explained by patterns in institutional ownership over the sample period. We document that our findings are associated with similar patterns in systematic risk. Our analysis also indicates that the ability to diversify systematic risk and aggregate liquidity shocks by holding large-cap stocks has declined. The evidence suggests that the fragility of the US equity market to unanticipated events has increased over the past few decades.     

Finance companies in Mexico: Unexpected victims of the global liquidity crunch

We study the connection between the global liquidity crisis and the severe credit crunch experienced by finance companies (SOFOLES) in Mexico using firm-level data between 2001 and 2011. Our results provide supporting evidence that, as a result of the liquidity shock, SOFOLES faced severely restricted access to their main funding sources (commercial bank loans, loans from other organizations, and public debt markets). After controlling for the potential endogeneity of their funding, we find that the liquidity shock explains 64 percent of SOFOLES’ credit contraction during the recent financial crisis (2008–2009). We use our estimates to disentangle supply from demand factors as determinants of the credit contraction. After controlling for the large decline in loan demand during the financial crisis, our findings suggest that supply factors (such as nonperforming loans and lower liquidity buffers) also played a significant role. Finally, we find that financial deregulation implemented in 2006 may have amplified the effects of the global liquidity shock.     

Dynamic effects of idiosyncratic volatility and liquidity on corporate bond spreads

We study the dynamic impact of idiosyncratic volatility and bond liquidity on corporate bond spreads over time and empirically disentangle both effects. Using an extensive data set, we find that both idiosyncratic volatility and liquidity are critical mainly for the distress portfolios, i.e., low-rated and short-term bonds; for others only volatility matters. The effects of volatility and liquidity shocks on bond spreads were both exacerbated during the recent financial crisis. Liquidity shocks are quickly absorbed into bonds prices; however, volatility shocks are more persistent and have a long-term effect. Our results overall suggest significant differences between how volatility and liquidity dynamically impact bond spreads.     

Funding liquidity risk: Definition and measurement

Funding liquidity risk has played a key role in all historical banking crises. Nevertheless, a measure for funding liquidity risk based on publicly available data remains so far elusive. We address this gap by showing that aggressive bidding at central bank auctions reveals funding liquidity risk. We can extract an insurance premium from banks’ bids which we propose as a measure of funding liquidity risk. Using a unique data set consisting of all bids in all auctions for the main refinancing operation conducted at the ECB between June 2005 and October 2008 we find that funding liquidity risk is typically stable and low, with occasional spikes especially around key events during the recent crisis. We also document downward spirals between funding liquidity risk and market liquidity. As measurement without clear definitions is impossible, we initially provide definitions of funding liquidity and funding liquidity risk.     

The effect of liquidity and arbitrage on the price efficiency of Chinese ETFs

We study the potential factors that determine the large and persistent price deviations in Chinese equity exchange-traded funds (ETFs). Our results suggest that ETF liquidity and arbitrage activity are positively correlated with ETF price efficiency, and the relation is more pronounced with higher institutional ownership. We also evaluate the effect of two exogenous shocks in the Chinese market. Using a policy change that added market makers to ETFs on the Shenzhen Stock Exchange (SZSE) and Shanghai Stock Exchange (SSE), we find that market makers improve price efficiency and that the impact is stronger for ETFs with lower liquidity. We also exploit a change in trading rules on the SZSE and show that the relaxation of arbitrage restrictions improves price efficiency. Altogether, these findings provide evidence that lack of liquidity, due to the unique market structure and regulations of the Chinese market, contributes to price inefficiency of Chinese ETFs.     

Crises,Liquidity Shocks,and Fire Sales at Commercial Banks

If liquidity shortages cause financial crises, a lender of last resort can provide funds to banks facing potential fire sales. However, if funding problems primarily occur at banks with existing solvency problems, then government liquidity programs may not spur bank lending. We find that commercial bank funding does not typically dry up in a crisis, not even during the subprime crisis. Rather, weak banks are more likely to borrow less. Furthermore, banks rely more on deposits and newly issued equity than fire sales. When they do sell assets, they cherry pick assets in order to alleviate pressure from capital regulations.     

Firms as liquidity providers: Evidence from the 2007–2008 financial crisis

Using a supplier–client matched sample, we study the effect of the 2007–2008 financial crisis on between-firm liquidity provision. Consistent with a causal effect of a negative shock to bank credit, we find that firms with high precrisis liquidity levels increased the trade credit extended to other corporations and subsequently experienced better performance as compared with ex ante cash-poor firms. Trade credit taken by constrained firms increased during this period. These findings are consistent with firms providing liquidity insurance to their clients when bank credit is scarce and offer an important precautionary savings motive for accumulating cash reserves.     

The impact of a new term auction facility on Libor–OIS spreads and volatility transmission between money and mortgage markets during the subprime crisis

During the subprime crisis, the U.S. Federal Reserve was concerned about widening spreads between overnight interbank lending rates such as the overnight index swap (OIS) and term London Interbank Offer Rate (Libor). Among the tools it used to counter the impact of the crisis, the innovative term auction facility (TAF) attracted much attention. We investigate the impact of the TAF on the Libor–OIS spread. We find that the TAF has clear initial and sustained expectation effects on the three-month Libor–OIS spread, but no real initial or short-term funding effects, which casts doubt on the usefulness of the TAF in reducing risk spreads. Since the subprime crisis also spilled across the interbank, commercial paper, and jumbo mortgage markets, we further examine the lead–lag relation between Libor–OIS, commercial paper, and jumbo spreads and the volatility transmission effects between them. For the period before the crisis, we find that the three markets behave largely independently. For the subprime crisis period, however, we find multidirectional lead–lag relations and one-way volatility transmission between these markets.     

Institutional trading and stock resiliency: Evidence from the 2007–2009 financial crisis

We examine the impact of institutional trading on stock resiliency during the financial crisis of 2007–2009. We show that buy-side institutions have different exposure to liquidity factors based on their trading style. Liquidity supplying institutions absorb the long-term order imbalances in the market and are critical to recovery patterns after a liquidity shock. We show that these liquidity suppliers withdraw from risky securities during the crisis and their participation does not recover for an extended period of time. The illiquidity of specific stocks is significantly affected by institutional trading patterns; participation by liquidity supplying institutions can ameliorate illiquidity, while participation by liquidity demanding institutions can exacerbate illiquidity. Our results provide guidance on why some stocks take longer to recover in a crisis.     

Cyclicality of liquidity creation: Nonlinear evidence from US bank holding companies

Using a panel smooth transition regression framework on a new proxy of the business cycle (BC) index and quarterly data of US bank holding companies from 1993Q1 to 2020Q1, our results provide empirical support for the theory that the BC has a nonlinear effect on liquidity creation. We find a positive and highly significant nonlinear effect of the BC on liquidity creation, which not only supports the pro-cyclicality of liquidity creation but also improves the liquidity creation estimation compared to previous studies. The results are robust to different proxies of the BC and model specifications. We also document that US bank holding companies create liquidity more during the expansion phase (normal times) than during the recession phase (crisis times) of the BC, suggesting an asymmetrical effect of BC changes on liquidity creation. Our findings have important implications for financial market participants by suggesting that banks should keep alternative sources of funding on hand during the BC recession phase. Insights from our study also provide policy implications for central banks and prudent supervisors to consider when incentivizing banks, for instance, by lowering regulatory requirements, adjusting the policy rate, or implementing any other quantitative easing policy during the BC recession phase to keep the financial system efficient.     

Spillover effects of the 2008 global financial crisis on the volatility of the Indian equity markets: Coupling or uncoupling? A study on sector-based data

This paper focuses on the following question: has the global financial stress in the US markets during the subprime crisis induced a persistent volatility of Indian equity stocks? We answer this question using sector-based data and we propose a simple stochastic volatility model augmented with exogenous inputs (financial stress indicators in the US market). We derive analytically the autocorrelation of the squared returns using cross-moments and estimate the impact of several variables such as the CDS spreads, the ABCP spreads, market liquidity, the volatility of the S&P 500 using a Kalman filter approach with the impact captured through Almon polynomials. We find a strong evidence of persistent volatility irrespective of the sector and interpret this finding as the result of two factors: the lower liquidity of the Indian equity markets during the subprime crisis and a wake-up call effect.     

Sell-order liquidity and the cross-section of expected stock returns

We estimate buy- and sell-order illiquidity measures (lambdas) for a comprehensive sample of NYSE stocks. We show that sell-order liquidity is priced more strongly than buy-order liquidity in the cross-section of equity returns. Indeed, our analysis indicates that the liquidity premium in equities emanates predominantly from the sell-order side. We also find that the average difference between sell and buy lambdas is generally positive throughout our sample period. Both buy and sell lambdas are significantly positively correlated with measures of funding liquidity such as the TED spread as well option implied volatility.     

Credit and liquidity components of corporate CDS spreads

This paper investigates the role of credit and liquidity factors in explaining corporate CDS price changes during normal and crisis periods. We find that liquidity risk is more important than firm-specific credit risk regardless of market conditions. Moreover, in the period prior to the recent “Great Recession” credit risk plays no role in explaining CDS price changes. The dominance of liquidity effects casts serious doubts on the relevance of CDS price changes as an indicator of default risk dynamics. Our results show how multiple liquidity factors including firm specific and aggregate liquidity proxies as well as an asymmetric information measure are critical determinants of CDS price variations. In particular, the impact of informed traders on the CDS price increases when markets are characterised by higher uncertainty, which supports concerns of insider trading during the crisis.     

Bank market power,asset liquidity and funding liquidity: International evidence

Our investigation of the association between bank market power and liquidity in 101 countries reveals that a bank's initial gains of market power lead to increases in bank liquidity, but does so at a diminishing rate. Beyond an empirically determined threshold, further increases in market power are inversely associated with bank liquidity. From a cross-sectional viewpoint, banks that lack market power hold more liquid assets and are net lenders in the interbank market. In contrast, dominant banks hold less liquid assets and are net interbank borrowers. For a given level of market power, ceteris paribus, developed nation banks hold less asset liquidity and obtain more interbank funding liquidity than their developing country peers. These results remain equally relevant during the 2007–2009 global financial crisis (GFC).