Money and Liquidity in Financial Markets

Abstract

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,” which involves selling financial assets either by banks directly or by levered investors. Empirical tests on the stock market are supportive. Tighter interbank markets are associated with relatively more volume in more liquid stocks; selling pressure, especially in more liquid stocks; and transitory negative returns. We control for market-wide uncertainty and in the process also contribute to the literature on portfolio rebalancing. Our general point is that money matters in financial markets.

Keywords: money, liquidity, interbank and financial markets, liquidity pull-back, volume, order imbalance, returns, portfolio rebalancing, Libor-OIS spread, VIX

JEL Classification: G12, G21, G11, E41, E44, E51