Slow Capital, Fast Prices: Shocks to Funding Liquidity and Stock Price Reversals

FEDS Working Paper No. 2015-043

http://dx.doi.org/10.17016/FEDS.2015.043

59 Pages Posted: 10 Jul 2015

See all articles by Stefan Gissler

Stefan Gissler

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: February 27, 2015

Abstract

A V-shaped price pattern is often observed in financial markets - in response to a negative shock, prices fall "too far" before reversing course. This paper looks at one particular channel of such patterns: the link between a liquidity provider's balance sheet and asset prices. I examine a well-identified historical case study where a large exogenous shock to a liquidity provider's balance sheet resulted in severe capital constraints. Using evidence from German universal banks, who acted as market makers for selected stocks in the interwar period, I show in a difference-in-differences framework that binding capital constraints made stocks 15-20 percent more likely to be illiquid if they were connected to the distressed liquidity provider. This resulted in V-shaped price patterns during times of illiquidity, where prices declined on average 2.5 percent and reversed over the next one to three days. Investing in these particular stocks would have yielded substantial gains. These findings can be rationalized by a model that incorporates imperfect competition and asymmetric information. Under this model, banks' market-making reduces price volatility (and uninformed traders' reactions to price movements) in normal times whereas in distressed times, the price impact of noise trading is high and leads to sharp price declines that are unrelated to fundamentals.

Keywords: Asset pricing and bonds, Banks, credit unions, and other financial institutions, Economic history, Equity, Liquidity

JEL Classification: G12, G14, G21, N24

Suggested Citation

Gissler, Stefan, Slow Capital, Fast Prices: Shocks to Funding Liquidity and Stock Price Reversals (February 27, 2015). FEDS Working Paper No. 2015-043, http://dx.doi.org/10.17016/FEDS.2015.043, Available at SSRN: https://ssrn.com/abstract=2628239 or http://dx.doi.org/10.2139/ssrn.2628239

Stefan Gissler (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
68
Abstract Views
586
rank
298,852
PlumX Metrics