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

Christoph G. Rösch and Christoph Kaserer

Journal of Banking & Finance, 2013, vol. 37, issue 7, 2284-2302

Abstract: 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.

Keywords: Financial crisis; Liquidity costs; Liquidity commonality; Market liquidity; Flight-to-liquidity; Flight-to-quality; Xetra liquidity measure (XLM) (search for similar items in EconPapers)
JEL-codes: G14 G15 (search for similar items in EconPapers)
Date: 2013
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Handle: RePEc:eee:jbfina:v:37:y:2013:i:7:p:2284-2302