Higher Liquidity Risk Research Articles

Liquidity Risk and Bank Stock Returns

We document that higher measures of liquidity risk on banks balance sheets are associated with lower expected stock returns. We first calculate a measure of liquidity risk, referred to as the liquidity gap (LG), which reflects how much of a bank's volatile liabilities are covered by its stock of liquid assets. We show that the standard factor models -- even when augmented with bond risk, market liquidity, and financial-size factors -- do not fully explain the cross section of bank stock returns sorted according to this measure. A portfolio that is long in low liquidity risk banks and short in high liquidity risk banks delivers a statistically significant alpha of 6 percent annually. This effect is not driven by bank characteristics such as size, profitability, or risk measures related to leverage or asset quality, but appears to be partly due to the degree of complexity of banking organizations and potential valuation errors pre-crisis.

Can Liquidity Risk Explain Diseconomies of Scale in Hedge Funds?

Using data from the Lipper TASS hedge fund database over the period 1994–2012, we examine the role of liquidity risk in explaining the relation between asset size and hedge fund performance. While a significant negative size-performance relation 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. 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 relatively more significant losses incurred during market-wide liquidity crises, resulting in lower performance for large funds relative to small funds.

Risk, Competition and Efficiency in Banking: Evidence from China

This paper tests the interrelationships between risk, competition and efficiency in the Chinese banking industry over the period 2003-2013 under a Granger Causality test. The current study contributes to the empirical research by using an Efficiency-adjusted Lerner index and stability inefficiency as the indicators of competition and insolvency risk and more importantly, it is the first piece of research testing the interrelationships between different types of risk, efficiency and competition in the context of Chinese banking. The results show that Chinese commercial banks with higher levels of efficiency have higher credit risk and insolvency risk, but lower liquidity risk and capital risk. Higher competition leads to lower credit risk, lower insolvency risk, but higher liquidity risk. The results further show that Chinese commercial banks with higher credit risk and insolvency risk have higher efficiency, but the impact is significant and negative for liquidity risk and capital risk. Finally, it is found that lower liquidity risk increases the market power (lower the competitive condition) in the Chinese banking industry.

Chinese Shadow Banking—Credit Creation Mechanism and Credit Expansion of Bank Financial Products

In China, shadow banking can be described as credit intermediations involving entities and activities outside the regular banking system broadly, also some non-bank credit entities and activities. Then we should pay more attention on shadow banking, which can particularly increase maturity and liquidity transformation, imperfect credit risk transfer and/or leverage by different financial tools. In our country, the financial system is dominated by commercial banks, so more and more internal financial innovations, especially bank financial products could be viewed as the representative of shadow banking. In essence, the process of bank financial products is not an independent credit creation, but it can enlarge the credit creation of commercial banks and enhance the scale of credit expansion by means of trust loans, entrusted loans, trust beneficiary, specific assets usufruct, and the asset pool, which will result in a higher liquidity risk. Therefore, expanding the scope of the legal deposit reserve rate, establishing more laws and regulations about bank financial products, and constantly improving the internal management mechanism of bank financial products are particularly important.

Liquidity shock management: Lessons from Australian banks

Prior to the 2007–2009 financial crisis, international banks had an average share of around 65% of the syndicated loan market in Australia. When the crisis hit, the resulting liquidity shock resulted in globally active international banks exiting the Australian market. With limited global operations, the major Australian banks were able to absorb and manage the liquidity shock. This resulted in domestic banks carrying a significantly greater proportion of revolving credit facilities in their syndicated loan portfolios after 2008. Domestic bank willingness and ability to deal with the market disruption and to hold a greater proportion of high liquidity risk revolvers are directly linked to the level of their transaction deposits. Their increased involvement in revolving facilities cannot be fully explained by the certification effect or flight-to-home effect. It is not demand driven and is robust to endogeneity tests.

Basel III LCR: A Regulatory Shock on a Bank and Beyond

This study investigates a regulatory spillover effect of the Basel III liquidity standard on the real economy through a series of difference-in-difference estimations. Since the Basel Committee’s official endorsement for the new liquidity regulation in December 2010, a bank exposed to high liquidity risk reduced its loan proportion significantly, making a negative real effect on its surrounding economy via a bank-lending-channel. The new regulation also induced a bank with a weak liquid balance sheet to raise its deposit rate aggressively, generating a liquidity problem in a nearby local bank through a deposit-competition-channel and ultimately curbing an expansion of the local bank’s credit supply to the economy.

Stock Liquidity Risk and the Cross-Sectional Earnings-Returns Relation

We argue that a higher sensitivity to aggregate market-wide liquidity shocks (i.e. a higher liquidity risk) implies a tendency for a stock’s price to converge to fundamentals. We test this intuition within the framework of the earnings-returns relation. We find a positive liquidity risk effect on the relation between return and expected change in earnings. This effect on the earnings-returns relation is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book-to-market; and (c) are profit making.

Stock Liquidity Risk and the Cross‐sectional Earnings‐Returns Relationship

AbstractWe argue that a higher sensitivity to aggregate market‐wide liquidity shocks (i.e., a higher liquidity risk) implies a tendency for a stock's price to converge to fundamentals. We test this intuition within the framework of the earnings‐returns relationship. We find a positive liquidity risk effect on the relationship between return and expected change in earnings. This effect on the earnings‐returns relationship is distinct from the negative effect observed for stock illiquidity level. Notably, the liquidity risk effect is evident (absent) during periods of neutral/low (high) aggregate market liquidity. We also show that the liquidity risk effect is dominant in firms that: (a) are of intermediate size; (b) are of intermediate book‐to‐market; and (c) are profit making.

Corporate social responsibility and bank risk profile: evidence from Europe

This study analyzes the impact of risk profile on sustainability reporting and its quality in European banks. Financial institutions (FI) play a social role in the financial inclusion process and incorporate environmental considerations into credit risk assessment, making corporate social responsibility (CSR)-related issues vital for risk management systems. FI with lower capital risk, higher liquidity risk, higher profitability in banking, and higher sensitivity to market risk tend to issue CSR reports. The findings suggest that FI with lower profitability in banking disclose higher quality CSR financial services sector (FSS)-specific information, whereas FI not submitting CSR reports for external assurance or having their CSR reports assured by certain auditors issue lower quality CSR/FSS-specific information.

CEO overconfidence and corporate debt maturity

This paper extends our knowledge of corporate debt maturity structure by examining whether and to what extent overconfident CEOs affect maturity decisions. Consistent with a demand side story, we find that firms with overconfident CEOs tend to adopt a shorter debt maturity structure by using a higher proportion of short-term debt (due within 12months). This behavior of overconfident CEOs is not deterred by the high liquidity risk associated with such a financing strategy. Our demand side explanation remains robust even after considering six possible alternative drivers including a competing supply side explanation (in which creditors are reluctant to extend long-term debt to overconfident CEOs).

The dynamics of hedge fund share restrictions

Nearly one in five hedge funds change their share restrictions (e.g., lockup) from 2007 to 2012. Using a large panel dataset, this paper is the first to empirically examine the incidence, determinants, and consequences of share restriction changes. We find that funds with high asset liquidity and low liquidity risk are more likely to decrease share restrictions and funds with good performance are more likely to increase share restrictions. A hazard model indicates that funds who actively manage liquidity concerns live longer by adjusting share restrictions. We examine whether changes in share restrictions create an endogeneity bias in the share illiquidity premium (Aragon, 2007) and find that 18% of the premium can be explained by the dynamic nature of contract changes.

The Impact of Competition on the Risk-Taking Behavior: Evidence from Chinese Banking Industry

The impact of competition on the risk-taking behavior has been examined extensively by the empirical research. However, most of the studies focused on European banking sector and there is no empirical study testing this issue with regards to Chinese banking industry. The current study contributes to the empirical literature by investigating the impact of competition on credit risk, liquidity risk, capital risk, security risk as well as insolvency risk in Chinese banking sector over the period 2003-2013. Three different bank ownership types are considered which are state-owned commercial banks, joint-stock commercial banks and city commercial banks. The insolvency risk is cross checked by stability inefficiency and Z-score, which is supposed to provide the most accurate results. In order to check the robustness of the results, the competition is measured by Lerner index and cross checked by Panzar-Rosse H statistics. The empirical findings suggest that city commercial banks have the highest credit risk and security risk compared to joint-stock commercial banks and state-owned commercial banks, while the liquidity risk of state-owned commercial banks is the highest. In terms of the capital risk, it is found that city commercial banks is lower than state-owned commercial banks, while the findings suggest that the insolvency risk of state-owned commercial banks is higher than joint-stock commercial banks and city commercial banks. In addition, the results show that higher competition within each bank ownership type leads to higher credit risk, higher liquidity risk, higher capital risk, higher security risk but lower insolvency risk.

Does competition only impact on insolvency risk? New evidence from the Chinese banking industry

PurposeThe purpose of this paper is to investigate the impact of competition on credit risk, liquidity risk, capital risk and insolvency risk in the Chinese banking industry during the period 2003-2013.Design/methodology/approachThis study uses a generalized method of moments system estimator to examine the impact of competition on risk. In particular, translog specifications are used to measure the competition and insolvency risk.FindingsThe results show that greater competition within each bank ownership type (state-owned commercial banks, joint-stock commercial banks and city commercial banks) leads to higher credit risk, higher liquidity risk, higher capital risk, but lower insolvency risk.Originality/valueThis paper is the first piece of research testing the impact of competition on different types of risk in banking industry and it further contributes to the empirical literature by using a more accurate competition indicator (efficiency-adjusted Lerner index) and a more precise insolvency risk indicator (stability inefficiency).

Market Liquidity, Funding Liquidity, and Hedge Fund Performance

This paper provides evidence on the interaction between hedge funds’ performance and their market liquidity risk and funding liquidity risk. Using a 2-state Markov regime switching model we identify regimes with low and high market-wide liquidity. While funds with high market liquidity risk exposures earn a premium in the high liquidity regime, this premium vanishes in the low liquidity states. Moreover, funding liquidity risk, measured by the sensitivity of a hedge fund’s return to the Treasury-Eurodollar (TED) spread, is an important determinant of fund performance. Hedge funds with high loadings on the TED spread underperform low-loading funds by about 0.49% (10.98%) annually in the high (low) liquidity regime, during 1994-2012. These results provide support for the Brunnermeier and Pedersen (2009) theoretical model that rationalizes the link between market liquidity and funding liquidity.

Credit lines as monitored liquidity insurance: Theory and evidence

We propose a theory of credit lines provided by banks to firms as a form of monitored liquidity insurance. Bank monitoring and resulting revocations help control illiquidity-seeking behavior of firms insured by credit lines. The cost of credit lines is thus greater for firms with high liquidity risk, which in turn are likely to use cash instead of credit lines. We test this implication for corporate liquidity management by identifying exogenous shocks to liquidity risk of firms in corporate bond and equity markets. Firms experiencing increases in liquidity risk move out of credit lines and into cash holdings.

Repo Narratives as a Strategic Management Tool

This study seeks to address Li (2010) call for further research examining accounting items in the context of disclosure analysis. In particular this study seeks to explain the amount and type of repo narratives in 10-K filings through the legitimacy and agency theories. I find that in line with the legitimacy theory, in response to a legitimacy crisis, banks seek to increase their disclosures to address a legitimacy gap. This increase is most apparent for banks most exposed to the legitimacy threat. Further analysis reveals that the agency theory can be used to explain impression management in repo narratives. In this regard I find that higher liquidity risk and higher stock-based compensation are associated with increased impression management through the characterization of repo transactions as sales in repo narratives.

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 (days when their constraint is likely to bind). Finally, DMMs reduce the size of pricing errors.

CEO Overconfidence and Corporate Debt Maturity

This paper extends our knowledge of corporate debt maturity structure by examining whether and to what extent overconfident CEOs affect maturity decisions. Consistent with a demand side story, we find that firms with overconfident CEOs tend to adopt a shorter debt maturity structure by using a higher proportion of short-term debt (due within 12 months). This behavior of overconfident CEOs is not deterred by the high liquidity risk associated with such a financing strategy. Our demand side explanation remains robust even after considering six possible alternative drivers including a competing supply side explanation (in which creditors are reluctant to extend long-term debt to overconfident CEOs).

Asset returns and liquidity effects: Evidence from a developed but small market

This study investigates an important question in the literature of whether there is a return premium for stocks with low liquidity and high liquidity risk. Using a sample of listed stocks in New Zealand from January 1996 to June 2011, we find that there is a significant illiquidity discount and that liquidity risk does not seem to be a priced factor. These results are robust to the presence of commonly known firm characteristics and risk factors.

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.