Market Liquidity in the Financial Crisis: The Role of Liquidity Commonality and Flight-to-Quality

36 Pages Posted: 3 Jan 2012 Last revised: 11 Sep 2012

Christoph G. Rösch

Technische Universität München (TUM)

Christoph Kaserer

Technische Universität München (TUM)

Date Written: January 3, 2012


We examine the dynamics and the drivers of market liquidity during the financial crisis, using a unique volume-weighted spread measure. According to the literature we find that market liquidity is impaired when stock markets decline, implying a positive relation between market and liquidity risk. Moreover, this relationship is the stronger the deeper one digs into the order book. Even more interestingly, this paper sheds further light on so far puzzling features of market liquidity: liquidity commonality and flight-to-quality. We show that liquidity commonality varies over time, increases during market downturns, peaks at major crisis events and becomes weaker the deeper we look into the limit order book. Consistent with recent theoretical models that argue for a spiral effect between the financial sector’s funding liquidity and an asset’s market liquidity, we find that funding liquidity tightness induces an increase in liquidity commonality which then leads to market-wide liquidity dry-ups. Therefore our findings corroborate the view that market liquidity can be a driving force for financial contagion. Finally, we show that there is a positive relationship between credit risk and liquidity risk, i.e., there is a spread between liquidity costs of high and low credit quality stocks, and that in times of increased market uncertainty the impact of credit risk on liquidity risk intensifies. This corroborates the existence of a flight-to-quality or flight-to-liquidity phenomenon also on the stock markets.

Keywords: financial crisis, market decline, liquidity costs, asset liquidity, market liquidity, price impact, weighted spread, Xetra liquidity measure (XLM), liquidity commonality, flight-to-quality, flight-to-liquidity, rating, credit risk, crisis

JEL Classification: G14, G15

Suggested Citation

Rösch, Christoph G. and Kaserer, Christoph, Market Liquidity in the Financial Crisis: The Role of Liquidity Commonality and Flight-to-Quality (January 3, 2012). Available at SSRN: or

Christoph G. Rösch (Contact Author)

Technische Universität München (TUM) ( email )

Arcisstrasse 21
Munich, 80333

Christoph Kaserer

Technische Universität München (TUM) ( email )

Arcisstr. 21
Munich, D-80290
+49 89 289 25489 (Phone)
+49 89 289 25488 (Fax)


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