Slow Capital, Fast Prices: Shocks to Funding Liquidity and Stock Price Reversals

Abstract

A V-shaped price pattern is often observed in financial markets – in response to a negative shock, prices fall \too far" before reversing course. This paper looks at one particular channel of such patterns: the link between a liquidity provider's balance sheet and asset prices. I examine a well-identified historical case study where a large exogenous shock to a liquidity provider's balance sheet resulted in severe capital constraints. Using evidence from German universal banks, who acted as market makers for selected stocks in the interwar period, I show in a difference-in-differences framework that binding capital constraints made stocks 15-20 percent more likely to be illiquid if they were connected to the distressed liquidity provider. This resulted in V-shaped price patterns during times of illiquidity, where prices declined on average 2.5 percent and reversed over the next one to three days. Investing in these particular stocks would have yielded substantial gains. These findings can be rationalized by a model that incorporates imperfect competition and asymmetric information. Under this model, banks' market{making reduces price volatility (and uninformed traders' reactions to price movements) in normal times whereas in distressed times, the price impact of noise trading is high and leads to sharp price declines that are unrelated to fundamentals.