A Liquidity Index

Abstract

The recent financial crisis reignited concerns about systemic risk in the financial industry. For the first time, systemic risk was caused by a lack of liquidity in the marketplace. To deal with this newly revealed systemic risk, researchers have developed various quantitative indicators. Despite successful empirical results, these indicators are mainly empirically based and are not capable of differentiating liquidity risk from other sources of risk, such as market and credit risks. In this article, the authors develop a liquidity index to measure the systemic risk caused by liquidity distress in the financial market. The index is based on a parsimonious model that has a semi-closed-form solution to compute a discount due to illiquidity. The model can be used to distinguish liquidity default from economic default (solvency). The authors construct their liquidity index using stocks in Standard & Poor’s 1500 financial sector index over the January 1996–December 2013 period. This liquidity index then can be used for various systemic risk analyses. They discover that there is large variation among banks in their liquidity health, that large banks suffer more liquidity discounts than smaller banks, but only a portion of banks suffered severely during the crisis. Using measured liquidity discounts, the authors relate their index to several financial variables used to represent financial distress or economic conditions in the academic literature.