The purpose of this paper is to explore what happens to market liquidity (ML) during market crashes when funding liquidity (FL) is frozen.
The authors employ an event study methodology in a multivariate regression framework to examine the dynamics of FL and ML before, during and after the financial crisis. They construct a matched sample to further analyze liquidity variations for financial and nonfinancial firms.
The authors test and find support for four predictions in Brunnermeier and Pedersen’s (2009) theoretical model. First, under heightened funding constraints, equity trading costs doubled during the crisis. Second, the FL-ML dynamics vary across firms, providing compelling support for the “flight to quality” hypothesis, where liquidity providers avoid high-volatility, financial and TARP recipient firms during periods of low FL. Third, a multivariate analysis reveals that funding constraints, as measured by TED spreads, net acquisition of financial assets and return on investment banks, are driving declines in ML. Finally, the study illustrates a nonlinear FL-ML relationship.
To the best of the authors’ knowledge, this study presents the first empirical evidence of a nonlinear relationship between funding constraints and market illiquidity. The findings highlight an intricate interplay between funding and market liquidity, underscoring the impact of regulatory measures and the need to manage funding liquidity for market stability.
