Money and Liquidity in Financial Markets

We argue that there is a connection between the interbank market for liquidity and the broader financial markets, which has its basis in demand for liquidity by banks. Tightness in the interbank market for liquidity leads banks to engage in what we term “liquidity pull-back”, e.g., selling assets in order to generate liquidity for themselves. By definition, trade in a highly liquid asset involves lower price impact, or transaction costs, on average than an equivalent trade in a less liquid asset. The implication, and our central hypothesis, is thus that increased tightness in the interbank market for liquidity is associated with an increase in the volume of more liquid assets relative to that of less liquid assets. Prices should also fall across the board, but not differentially so across assets with different “liquidity levels.” We confirm these hypotheses on the CRSP universe of stocks using the three month Libor-OIS and TED spreads as measures of tightness in the interbank market. – All the rivers run into the sea; yet the sea is not full: unto the place from whence the rivers come, thither they return again.