An Empirical Analysis of Eurozone Government Bonds Liquidity: Determinants, Predictability and Implications for the New Bank Prudential Rules

Abstract

Based on a large and representative data set we investigate the liquidity of Eurozone government bonds in ordinary times as well as in periods of market turmoil looking at the behavior of several liquidity indicators from 2005 to 2012. We find that the effect of adverse market conditions on liquidity strongly depends on individual bond’s characteristics. We then analyze the relative performance of different liquidity metrics. This allows us to discuss the appropriateness of the inclusion criteria for liquid assets used by the Basel Committee and the European Union. Our evidence argues for rules on HQLAs that should constrain the eligibility of government bonds depending on their characteristics (primarily, duration and rating). We also study the persistence of liquidity measures over time to assess which indicators might be used to anticipate future bond liquidity, especially ahead of market-wide crises. Based on rank correlation analysis we find that a wide array of liquidity metrics can provide stable indications over time.

Keywords: liquidity risk; liquidity coverage ratio; high-quality liquid assets (HQLAs); Basel 3; Basel Committee

JEL Classification: G18, G19, G29