Higher Liquidity Risk Research Articles

Credit Lines as Monitored Liquidity Insurance: Theory and Evidence

We propose and test a theory of corporate liquidity management in which credit lines provided by banks to firms are a form of monitored liquidity insurance. Bank monitoring and resulting credit line revocations help control illiquidity-seeking behavior by firms. Firms with high liquidity risk are likely to use cash rather than credit lines for liquidity management because the cost of monitored liquidity insurance increases with liquidity risk. We exploit a quasi-experiment around the downgrade of General Motors (GM) and Ford in 2005 and find that firms that experienced an exogenous increase in liquidity risk (specifically, firms that relied on bonds for financing in the pre-downgrade period) moved out of credit lines and into cash holdings in the aftermath of the downgrade. We observe a similar effect for firms whose ability to raise equity financing is compromised by pricing pressure caused by mutual fund redemptions. Finally, we find support for the model's other novel empirical implication that firms with low hedging needs (high correlation between cash flows and investment opportunities) are more likely to use credit lines relative to cash, and are also less likely to face covenants and revocations when using credit lines.

Systematic liquidity risk and stock price reaction to shocks

AbstractThis study examines the relationship between systematic liquidity risk and stock price reaction to large 1‐day price changes (or shocks). We base our analysis on a yearly updated constituents list of the FTSE All share index. Our overall results are consistent with the price continuation hypothesis, which suggests that positive (negative) shocks will be followed by positive (negative) abnormal returns. However, further analysis indicates that stocks with low systematic liquidity risk react efficiently to both positive and negative shocks, whereas stocks with high systematic liquidity risk underreact to both positive and negative shocks. Our results are valid irrespective of various robustness tests such as size of the shock, size of the firm, month‐of‐the‐year and day‐of‐the‐week effects. We conclude that trading on price patterns following shocks may not be profitable, as it involves taking substantial liquidity exposure.

How Do Designated Market Makers Create Value for Small-Caps?

A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days, i.e., days when their constraint is likely to bind. Finally, DMMs reduce the size of pricing errors.

Can Liquidity Risk Explain the Size-Performance Relationship for Hedge Funds?

Using data from the Lipper TASS hedge fund database over 1994-2012, we examine the role of liquidity risk in explaining the relationship between asset size and hedge fund performance. While a significant negative size-performance relationship exists for all hedge funds, once we stratify our sample by liquidity risk, we find that such a relationship only exists among funds with the highest liquidity risk. This result cannot be explained away by the liquidity hypothesis or the leverage effect. Liquidity risk is found to be another important source of diseconomies of scale in the hedge fund industry. Evidently, for high liquidity risk funds, large funds are less able to recover from the more significant losses incurred during market-wide liquidity crises, resulting in lower performance for large funds relative to small funds.

Financial Amplification Mechanisms and the Federal Reserve's Supply of Liquidity During the Crisis

The small decline in the value of mortgage-related assets relative to the large total losses associated with the financial crisis suggests the presence of financial amplification mechanisms, which allow relatively small shocks to propagate through the financial system. We review the literature on financial amplification mechanisms and discuss the Federal Reserve’s interventions during different stages of the crisis in light of this literature. We interpret the Fed’s early-stage liquidity programs as working to dampen balance sheet amplifications arising from the positive feedback between financial constraints and asset prices. By comparison, the Fed’s later-stage crisis programs take into account adverse-selection amplifications that operate via increases in credit risk and the externality imposed by risky borrowers on safe ones. Finally, we provide new empirical evidence that increases in the Federal Reserve’s liquidity supply reduce interest rates during periods of high liquidity risk. Our analysis has implications for the impact on market prices of a potential withdrawal of liquidity supply by the Fed.

Testing seasonality in the liquidity–return relation: Japanese evidence

We study liquidity (share turnover) effects of stock returns and their seasonality using Japanese data. We find a significant and negative turnover/return relation. Moreover, we find that the liquidity effect is not impacted by either January or June seasonality. There is weak evidence that stocks with higher liquidity risk have on average higher rates of return for non-June months.

Volatility and growth: Credit constraints and the composition of investment

Abstract How does uncertainty and credit constraints affect the cyclical composition of investment and thereby volatility and growth? This paper addresses this question within a model where firms engage in two types of investment: a short-term one; and a long-term one, which contributes more to productivity growth. Because it takes longer to complete, long-term investment has a relatively less cyclical return; but it also has a higher liquidity risk. The first effect ensures that the share of long-term investment to total investment is countercyclical when financial markets are perfect; the second implies that this share may turn procyclical when firms face tight credit constraints. A novel propagation mechanism thus emerges: through its effect on the cyclical composition of investment, tighter credit can lead to both higher volatility and lower mean growth. Evidence from a panel of countries provides support for the model's key predictions.

Systematic Liquidity Risk and Stock Price Reaction to Shocks: Evidence from London Stock Exchange

This study examines the relationship between systematic liquidity risk and stock price reaction to large one-day price changes (or shocks). We base our analysis on 642 constituents of the FTSEALL share index. Our overall results are consistent with Brown et al.’s (1988) uncertain information hypothesis. However, further analysis suggests that stocks with low systematic risk react efficiently to shocks of different signs and magnitudes whereas stocks with high systematic liquidity risk overreact to negative shocks and underreact to positive shocks. Thus, trading on price patterns following shocks may not be profitable, as it involves taking substantial systematic liquidity risk.

How Do Designated Market Makers Create Value for Small-Caps?

A poor liquidity level and a high liquidity risk significantly raise the required return for small-cap stocks. Euronext allows these firms to hire designated market makers (DMMs) who guarantee a minimum liquidity supply for a lump sum annual fee. In an event study based on 74 DMM stocks, we find that the contract improves liquidity level, reduces liquidity risk, and generates an average abnormal return of 3.5%. DMMs participate in more trades and incur a trading loss on high quoted-spread days, i.e., days when their constraint is likely to bind. Finally, DMMs reduce the size of pricing errors.

Determinants of yield spread dynamics: Euro versus US dollar corporate bonds

This paper presents a systematic comparison between the determinants of euro and US dollar yield spread dynamics. The results show that US dollar yield spreads are significantly more affected by changes in the level and the slope of the default-free term structure and the stock market return and volatility. Surprisingly, euro yield spreads are strongly affected by the US (and not the euro) level and slope. This confirms the dominance of US interest rates in the corporate bond markets. Interestingly, I find that liquidity risk is higher for US dollar corporate bonds than euro corporate bonds. For both regions, the effect of changes in the bid-ask spread is mainly significant during periods of high liquidity risk. Finally, the results indicate that the credit cycle as measured by the region-specific default probability significantly increases US yield spreads. This is not the case for euro yield spreads.

Liquidity Risk and Venture Capital Finance

This article provides theory and evidence in support of the proposition that venture capitalists adjust their investment decisions according to liquidity conditions on IPO exit markets. We refer to technological risk as a choice variable in terms of the characteristics of the entrepreneurial firm in which the venture capitalist invests, and liquidity risk as the current and expected future external exit market conditions. We show that in times of expected illiquidity of exit markets (high liquidity risk), venture capitalists invest proportionately more in new high-tech and early-stage projects (high technology risk) in order to postpone exit requirements. When exit markets are liquid, venture capitalists rush to exit by investing more in later-stage projects. We further provide complementary evidence that shows that conditions of low liquidity risk give rise to less syndication. Our theory and supporting empirical results facilitate a unifying theme that links related research on illiquidity in private equity.

Volatility and Growth: Credit Constraints and Productivity-Enhancing Investment

We examine how credit constraints affect the cyclical behavior of productivity-enhancing investment and thereby volatility and growth. We first develop a simple growth model where firms engage in two types of investment: a short-term one and a long-term productivity-enhancing one. Because it takes longer to complete, long-term investment has a relatively less procyclical return but also a higher liquidity risk. Under complete financial markets, long-term investment is countercyclical, thus mitigating volatility. But when firms face tight credit constraints, long-term investment turns procyclical, thus amplifying volatility. Tighter credit therefore leads to both higher aggregate volatility and lower mean growth for a given total investment rate. We next confront the model with a panel of countries over the period 1960-2000 and find that a lower degree of financial development predicts a higher sensitivity of both the composition of investment and mean growth to exogenous shocks, as well as a stronger negative effect of volatility on growth.

Bank Safety and Soundness and the Structure of Bank Supervision: A Cross‐Country Analysis

Two central questions about the structure of bank supervision are whether central banks should supervise banks and whether to have multiple supervisors. We use data for 70 countries across developed, emerging and transition economies to estimate statistical connections between banking performance, the structure of bank supervision, permissible banking activities, legal environments, banking market structure and macroeconomic conditions. We find that where central banks supervise banks, banks tend to have more non‐performing loans. Countries with multiple supervisors have lower capital ratios and higher liquidity risk. We also find that conclusions from non‐transition economies may not necessarily apply to transition economies.

The Interaction of Solvency with Liquidity and its Association with Bankruptcy Emergence

Prior research has shown that accounting information available prior to a bankruptcy is associated with the likelihood of bankruptcy. We show that additionally, the accounting information available prior to bankruptcy is associated with whether or not a firm will emerge from bankruptcy. We predict that firms that exhibit low solvency risk and high liquidity risk are most likely to emerge from bankruptcy. Firms that exhibit high solvency risk and high liquidity risk are predicted to be least likely to emerge from bankruptcy. Cross–sectionally, our results support these predictions, but our findings differ across large and small firms.

The Interaction of Solvency with Liquidity and its Association with Bankruptcy Emergence

Prior research has shown that the accounting information available in the year just prior to filing bankruptcy is associated with the likelihood of filing for Chapter 11 protection. This information, however, is more predictive of bankruptcy for stressed firms than for non-stressed firms. We extend this line of research by showing that in addition to being associated with bankruptcy, the accounting information available in the year just prior to a firm filing for bankruptcy protection is also associated with whether or not a firm will emerge from Chapter 11 bankruptcy. We classify stress as either long-term stress (solvency risk) and short-term stress (liquidity risk) and predict that firms that exhibit low solvency risk and high liquidity risk are most likely to emerge from bankruptcy. Firms that exhibit high solvency risk and high liquidity risk are predicted to be least likely to emerge from bankruptcy. Cross-sectionally, our results generally support these predictions, but our findings differ across large and small firms.

Stock Market Reaction to Regulatory Action in the Continental Illinois Crisis

Continental Illinois Corporation is a whose principal subsidiary is Continental Illinois National Bank, a wholesale unit bank.' In December 1983, it was the eighth largest in the United States and the largest in the Midwest. It had assets of $42.1 billion, 75% of which were financed by rate sensitive liabilities.2 Restricted by Illinois law from branching, Continental relied heavily on large deposits from other domestic banks (about 16%) and on foreign deposits (40%). These were liquid short-term deposits, and their withdrawal was the precipitating factor in the virtual collapse of the in May 1984. Moreover, insured deposits amounted to only $3 billion (Isaac 1984, p. 3). Thus Continental Illinois was bearing high liquidity risk and interest rate risk, relative to other money center banks. This study examines the stock market reaction to the Continental Illinois crisis and the regulatory action taken in response to that crisis. Through the use of stock market data, this study reveals that there was significant market response to the crisis in terms of both negative abnormal returns and positive abnormal volume of trading. The most significant effect was found in those banks that had a large amount of Latin American debt and other nonperforming assets. But while there was a clear market reaction to information revealed in the crisis about banks' asset quality and regulatory policy, depositors apparently did not withdraw funds in the massive way that regulators anticipated. * I am grateful for the comments and suggestions of Joseph Aharony, Gabriel Hawawini, Barbara Paul, Ramon Rabinovitch, Anthony Saunders, Henny Sender, and the referees of this Journal. 1. The distinction between the and the is an important regulatory issue in the Continental Illinois crisis and is discussed later (see Black, Miller, and Posner 1978; Swary 1983). The terms bank and holding company are used interchangeably. 2. For various measures of these risks and an industry comparison, see Bank Analysts' Quarterly Handbook (1984).