Bank leverage constraints and bond market illiquidity during the COVID-19 crisis

Johannes Breckenfelder and Victoria Ivashina

Research Bulletin, 2021, vol. 89

Abstract: The outbreak of the coronavirus (COVID-19) pandemic led to heightened uncertainty and a “dash-for-cash” in March 2020. Investors moved out of risky assets and into safe assets. The mutual fund sector in particular was hit by unprecedented investor redemptions and faced fire sale pressure as a result. Typically, banks that engage in securities trading – dealer banks – absorb such bond sales, supporting market liquidity, but regulation may limit their ability to do so by requiring them to maintain a certain leverage ratio. In recent research, we analyse the role of bank leverage constraints as an amplifier of bond market illiquidity during the March 2020 crisis. Our analysis links mutual funds bond holdings to dealer banks and their leverage constraints. We document that mutual funds that were holding more bonds exposed to dealer bank constraints in their portfolio faced bigger selling pressure in March 2020. We provide supplementary evidence that bank leverage constraints affect bond liquidity, using the introduction of leverage ratio regulation in the euro area. JEL Classification: G12, G18, G21

Keywords: Bond liquidity; capital requirements; COVID-19; leverage ratio; market-making; mutual funds (search for similar items in EconPapers)
Date: 2021-11
Note: 1125999
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