Essays on liquidity and funding frictions

Paulus, Ellen (2014) Essays on liquidity and funding frictions. Doctoral thesis, University of London: London Business School.

Abstract

This thesis combines an introductory chapter and three essays on liquidity and funding frictions in financial markets. Funding liquidity is a broad and elusive concept that generally denotes the ability to raise funds against collateral, quickly and at low cost. Despite being relevant to the trading activity in almost all financial markets, we know little about the empirical properties of funding liquidity. This is largely due to a lack of publicly available data. The first essay of this thesis has as objective to study the characteristics of funding liquidity in equity markets. To this end, I develop a new measure of aggregate equity-collateralized funding liquidity based on data from the stock lending market. I analyze the co-movement of funding liquidity with other variables that are considered important for equity prices and test whether expected stock returns are cross-sectionally related to the sensitivities of returns to fluctuations in aggregate funding illiquidity, controlling for fluctuation in aggregate market liquidity. I find evidence that changes in funding illiquidity matter for equity prices through an aggregate market liquidity channel. In particular, I show that a portfolio's liquidity risk is not determined by its unconditional correlation with aggregate market liquidity, but by its correlation conditional on the state of changes in funding illiquidity. This first essay prepares the ground for an empirical test of the interaction of market liquidity and funding liquidity, as theoretically documented in Gromb and Vayanos (2002, 2010) and Brunnermeier and Pedersen (2009). I conduct such a test in the second essay. The second essay of this thesis presents the results of my work with Kris Boudt and Dale Rosenthal. Using the new measure for equity-collateralized funding liquidity, we study the effect of market liquidity on funding liquidity, controlling for endogeneity. Theory suggests market liquidity can aect funding liquidity in stabilizing and destabilizing manners. We provide the first evidence of stabilizing financier behavior and confirm the existence of two regimes over the period of July 2006-May 2011. Furthermore, we show that we can separate the two regimes using the yield spread of Eurodollars over T-bills (TED spread) and that a regime switch occurs near a TED spread of 48 basis points. While the first two essays of this thesis strictly relate to the financial sector's supply of, and demand for, private liquidity, the last essay of this thesis shifts its attention to the supply of public liquidity. In this essay, I ask the question how the stringency of a Central Bank's Lending Facility affects the risk-taking behavior of a financial firm. To answer this question, I develop a model of collateralized lending in which the Central Bank chooses the maximum amount of funds it is willing to inject in the financial sector. In response, a financial firm chooses the exposure of its investment to funding risk. I show that financial risk-taking is non-monotonic with respect to the Lending Facility's loan ceiling. While a strict lending policy can reduce risk-taking below its autarky level, a generous lending policy can result in socially excessive risk-taking due to an asset substitution effect. When funding risk is highly elastic and the financial firm has a weak investment outlook, this prohibits the implementation of of first-best. Otherwise, socially optimal lending standards vary over the business cycle.