Dynamics of Market Liquidity and Funding Liquidity during Financial Crisis, Its Resolution, and the Volcker Rule

Abstract

We provide the first empirical evidence of a non-linear relationship between funding liquidity and market liquidity (FL-ML). The relationship depends on the state of business cycle, firm volatility, and the regulatory regime. Due to heightened funding constraints, equity trading costs increased twofold during the recent financial crisis; and even more for low quality firms, confirming the “flight to quality” hypothesis. The FL-ML relationship strengthens after favorable bank stress test results indicating the importance of market intermediation by bank affiliates. The relationship weakens after the enactment of the Volcker Rule as Volcker rule prohibits proprietary trading by banks.