Ebook Money and Liquidity in Financial Markets
We study the connection between the interbank market for liquidity and the broader financial markets. That such a connection exists is suggested, for example, by the experience of the recent financial crisis, where we saw both a breakdown in the interbank market and a collapse in the prices of financial assets. There is also evidence in the extant literature that financial markets are affected by monetary phenomena. For example, returns in bond and equity markets appear to be influenced by monetary shocks (Fleming and Remolona 1997, Fair 2002, Piazzesi 2005) and fund flows (Edelen and Warner 2001, Boyer and Zheng 2009, Goetzmann and Massa 2002), as are measures of liquidity in these markets (Chordia, Sarkar, and Subrahmanyam, 2005). However, we are not aware of research that explicitly documents a link between the interbank market and the broader financial markets, as we do in this paper.
Our motivation for this line of inquiry has its basis in a money and banking perspective on financial market activity. Banks need liquidity, or central bank money, to satisfy reserve requirements, allow depositor withdrawals, etc. The central bank determines the quantity of liquidity via its operations and then the interbank market (re)allocates it. However, if the price of liquidity in the interbank market is high, alternative sources of liquidity may be more attractive. Banks that have exhausted credit limits, must look for alternative sources. But to paraphrase Friedman (1970), “One bank can increase its money balances only by persuading another one to decrease its balances.” And as emphasized by Tobin (1980), “The nominal supply of money is something to which the economy must adapt, not a variable that adapts itself to the economy unless the policy authorities want it to.” So what alternatives to the interbank market are there?
Banks have, in fact, several alternatives. They can go to the discount window, but this is expensive and a last resort. They can try to induce more deposits, but this is unlikely to be effective within a short time span. Rather, the alternative that we wish to emphasize here, is selling financial assets and/or increasing margins to investors, which in turn may lead to asset sales as investors seek to meet margin requirements. This does not increase the quantity of liquidity in the system, but it can increase the selling bank’s liquidity balances, as long as the buying counterparty banks with another bank. One can think of this as a kind of “liquidity pull-back,” where a bank dips its ladle into the “ocean” of financial assets and recovers, for itself, liquidity granted to a counterparty some time in the past and stored all the while in the financial asset that now is being sold.
Thus, we argue that there is a connection between the interbank market for liquidity and the broader financial markets arising from (the possibility of) liquidity pull-back. There are two potential facets to this connection. First, a higher price of liquidity, ceteris paribus, should be associated with offsetting drops in asset prices. This is so as to equalize, insofar as possible, the cost of acquiring liquidity directly in the interbank market versus acquiring it indirectly by selling assets in the financial markets. The other facet of the connection relates to the volume of trade. This will be the main focus of our empirical analysis and to which we now turn.
Liquidity pull-back trading is arguably most likely to occur if the interbank market is not allocatively efficient. The crisis is an example of it being so; volume in the interbank market fell (Cassola, Holthausen, and Lo Duca, 2008) while central banks around the world injected vast amounts of liquidity to counteract banks’ unwillingness to lend to each other. In addition, Bindseil, Nyborg, and Strebulaev (2009) find evidence that there is a degree of allocational inefficiency in the interbank market even during what we think of as times of normalcy, and Fecht, Nyborg, and Rocholl (2008) find evidence that interbank liquidity networks, which are intended to overcome imperfections in the interbank market, are not always effective.
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