Liquidity Based Indicators of the Financial Crisis and Its Resolution

Bill Hu
Assistant Professor of Finance
College of Business
Arkansas State University
State University, AR 72467
Phone: (870) 972-2470
Fax: (870) 972-3417
E-Mail: xhu@astate.edu


Chinmay Jain
Doctoral Candidate of Finance
Fogelman College of Business and Economics
The University of Memphis
Memphis, TN 38152
Phone: (901) 652-9319
E-Mail: cjain1@memphis.edu


Pankaj Jain
Associate Professor of Finance
Fogelman College of Business and Economics
The University of Memphis
Memphis, TN 38152
Phone: (901) 678-3810
E-Mail: pjain@memphis.edu







September, 2011

1

Liquidity Based Indicators of the Financial Crisis and Its Resolution

Abstract
Equity trading costs increase almost threefold during the recent financial crisis. Using
Granger causality tests, we document that liquidity providers funding constraints lead to
significant declines in stock market liquidity. Furthermore, this effect is heightened during the
crisis period for all firms, and is especially strong for the troubled firms, particularly after the
announcement of TARP. The relationship between funding and market liquidity is always
stronger for financial firms compared to non-financial firms, and is the strongest for too-big-to
fail firms.

JEL Classification: G1, G2
Key Words: Financial crisis, market liquidity, funding liquidity
2

1. Introduction
Market liquidity is a key determinant of the stability and efficiency of capital markets. In
a liquid capital market, there are buyers and sellers willing to trade large quantities quickly
without moving the market price too much. What happens to market liquidity during market
crashes? Is liquidity readily available when it is needed the most? Bernanke (1983) predicts that
financial crisis increases the cost of intermediation and thus leads to increases in trading costs.
Brunnermeier and Pedersen (2009) show that market liquidity deteriorates when the supply of
capital is tight. They predict that market liquidity and funding liquidity decrease together and this
phenomenon leads to liquidity spirals. In his 2010 AFA presidential address, Duffie (2010)
points out that slow movement in capital significantly influences asset pricing dynamics. Supply
or demand shocks cause a significant price change in one direction initially, followed by a
gradual reversal in the opposite direction. Taking the immediate price impact into consideration,
trading costs may increase sharply at first and then slowly reverse to normal levels. According to
these models, when facing funding constraints, traditional liquidity providers may become
reluctant to take on new positions, especially capital intensive positions.
In this study, we test three predictions about stock market liquidity and its relationship
with funding liquidity in the context of the recent financial crisis. First, using a battery of market
liquidity measures, we investigate the deterioration of stock market liquidity during the recent
financial crisis as well as its subsequent recovery after the bailout measures. Second, we test
whether funding liquidity is a key determinant of market liquidity. Brunnermeier and Pedersen
(2009) suggest a novel line of empirical work that test their theoretical model at a deeper level,
namely, its prediction that funding constraints of speculators, intermediaries, and other liquidity
providers are a driving force underlying the market liquidity effects. Third, we analyze the
3

dynamics between stock market liquidity and funding liquidity during the financial crisis and the
subsequent recovery periods. Specifically, we examine the importance of funding liquidity
separately for financial versus non-financial firms, large financial versus small financial firms,
too-big-to-fail firms, TARP recipient firms, and during crisis versus normal periods.
We find that market liquidity indeed deteriorates during the recent financial crisis as
predicted by Bernanke (1983). The relative effective spread increases almost threefold from 5.97
basis points in the pre-crisis benchmark period to 16.34 basis points during the financial crisis
which began with the collapse of Lehman Brothers. When the U.S. Treasury and the Federal
Reserve System began to bail out large banks and insurance companies, the relative effective
spread reduced marginally to 13.33 basis points. Only in the long-term recovery period ending
one year after the crisis, relative effective spread fell to 8.57 basis points. Other measures of
liquidity such as relative quoted spread and relative realized spread responded similarly to the
crisis and recovery efforts. During the crisis period, the relative effective spreads are higher than
the relative quoted spread. It seems that liquidity demanders are more aggressive and trading
quantities beyond the quoted depth. Time series comparisons of quoted and realized spreads
suggest that liquidity providers become very sensitive to the uncertainty created by the crisis and
conservatively quote wider spreads even though there is no evidence of any increase in adverse
selection costs from trading against more informed traders. The increased quoted spreads
appeared to have passed on to liquidity providers in the form of higher relative realized spreads.
The deterioration in market liquidity occurs despite an increase in trading activities. For
example, the average daily number of trades per stock increases from 34,040 in the pre-crisis
benchmark period to 88,640 in crisis period. During the long-term recovery period, the number
of trades reverses back to 44,740. The financial stocks suffer from a much sharper deterioration
4

in their liquidity relative to matching non-financial stocks. For example, although the difference
in the relative quoted spread between financial and non-financial stocks is insignificant at 0.06
basis points during the pre-crisis benchmark period, this number increases to a significant 3.04
basis points during the crisis period. The difference in relative quoted spread declines during the
bailout and long-term recovery period, but remains economically and statistically significant. In
summary, several measures of trading costs increase significantly during the crisis, especially for
financial stocks, but are gradually restored to the pre-crisis level within a period of one year.
Next, we examine the relationship between funding liquidity and market liquidity.
Brunnermeier and Pedersen (2009) describe several real-world margin constraints and funding
requirements for hedge funds, commercial and investment banks, and market makers. We use
two alternative measures of funding constraints, the TED spread and NETACQ. The TED spread
is the difference between the 3-month LIBOR (London Interbank Offered Rate) and the 3-month
U.S. Treasury bill rate. NETACQ is the net acquisition of financial assets by security brokers and
dealers and is available from the Federal Reserve Statistical Release about flow of funds
accounts. Adrian and Shin (2008) suggest that aggregate liquidity co-move with the aggregate
balance sheet of the financial intermediaries. When asset prices fall, the size of intermediaries
balance sheet shrinks and such developments interfere with their liquidity supply function. If
liquidity providers approach their funding limits, they may actually start demanding liquidity
through aggressive selling of securities. If other traders send large blocks of shares to be sold in
the market too, transaction costs would increase significantly and at the same time the prices
would drop quickly. While Hameed, Kang, and Viswanathan (2010) find a positive relationship
between funding liquidity and market liquidity for a period from 1988 to 2003, we demonstrate a
dramatic tightening of this relationship during the recent financial crisis. Our analysis highlights
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the dynamic nature of the relationship between funding liquidity and market liquidity, which is
more acute during the crisis period than during normal or bailout periods. Another unique feature
of our analysis is a Granger causality test which indicates that a decline in funding liquidity
deteriorates market liquidity, but not vice-versa.
We continue our investigation to understand the determinants of the relationship between
funding liquidity and stock market liquidity. The Federal Reserve and other central banks have
implemented various measures such as TARP to enhance funding liquidity in response to the
financial crisis. For troubled firms, the relationship between funding and market liquidity is more
intense, particularly after the announcement of TARP. The relationship is always stronger for
financial firms compared to non-financial firms, and is the strongest for too-big-to fail firms.
Finally, our study provides a detailed analysis of the liquidity changes in response to the U.S.
governments intervention in resolving the crisis. Crisis resolution measures stalled a further
decline in market liquidity but it took more than a years work and wait before liquidity could be
restored to its pre-crisis levels.

2. Background, literature review and hypotheses development
2.1. The financial crisis of 2007-2009 and regulatory responses
The financial crisis of 2007-2009 started with seemingly small subprime mortgage losses,
which were only about 5 percent of overall stock market capitalization. As more and more
people defaulted on underwater home loans and house prices declined precipitously, the problem
quickly spread to the mainstream markets with dire consequences for the global financial system.
The financial turmoil intensified in the fall of 2008, when Lehman Brothers filed for bankruptcy
and interbank interest rates spiked. More than 160 banks failed during 20082009 in contrast to
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only 11 bank failures during 2003-2007.

1
Credit markets came to a grounding halt and stock
markets plunged as well. During the first two weeks of October 2008, both the Dow Jones
Industrial Average and the Standard and Poor 500 Index declined by over 20 percent. Stock
markets worldwide had mostly declined alongside.
To rescue the financial system and avoid economic recession, various short term and
long-term strategies were developed and implemented by the United States and other countries.
The United States executed two stimulus packages, totaling nearly $1 trillion during 2008 and
2009. The U.S. government also implemented a 700 billion troubled asset relief program (TARP)
aimed at restoring liquidity in the financial markets. The U.S. Treasury took over Fannie Mae
and Freddie Mac in September 2008 in an attempt to shore up the nation's falling housing market.
Gorton and Huang (2004), who model liquidity, efficiency, and bank bailouts, show that
governments can efficiently provide liquidity by issuing government securities to bailout the
banking system.
In the long run, many regulatory changes have been proposed by economists, politicians,
journalists, and business leaders to minimize the impact of the financial crisis and prevent its
recurrence. The United States introduced a series of regulatory proposals to address consumer
protection, executive pay, bank financial cushion or capital requirements, expanded regulation of
the shadow banking system and derivatives, and enhanced authority for the Federal Reserve to
safely wind-down systemically important institutions, among others. Regulations targeted at
corporate disclosure may further improve confidence in financial markets. For example, Bushee
and Leuz (2005) document that the firms in compliance with the SEC mandatory disclosure rule
changes benefit significantly through positive stock returns and improvements in market

1
http://www.fdic.gov/bank/individual/failed/banklist.html
7

liquidity. Eleswarapu, Thompson, and Venkataraman (2004) find that market liquidity improved
after the Regulation Fair Disclosure (Reg. FD).
The U.S. bailout of troubled assets and coordinated international rescue seem to inject
some confidence in the financial markets. By the second quarter of 2009, major stock market
indices had stabilized and started to bounce back. The results of stress tests conducted on major
banks in the United States in May 2009 were much better than feared and helped drive the stock
prices of these banks significantly higher from their lows. The TED spread, which peaked at 458
basis points in October 2008 had gradually fallen back to the normal levels around 30 basis
points in August 2009. The U.S. GDP growth rate also returned to a positive territory albeit the
unemployment rate remained high.
2.2. Impact of the financial crisis on liquidity and transaction costs
There are three ways a financial crisis can affect the real economy (Bernanke (1983)).
First, the crisis reduces the wealth of banks shareholders. Second, the crisis may lead to a rapid
fall in the money supply. Third, the crisis increases the cost of intermediation and reduces the
effectiveness of financial sectors in performing market making between borrowers and lenders,
or buyers and sellers. Grossman and Miller (1988) demonstrate that it is costly for market
makers to maintain market presence during a crisis. Duffie (2010) predicts that market liquidity
worsens when there is a large negative shock in asset prices. In this study, we empirically study
the effects of increasing cost of intermediation on market liquidity. Specifically, we hypothesize:
Hypotheses 1: Market liquidity deteriorates during the financial crisis.
Recent literature on the role of liquidity in asset pricing focuses on the relationship
between funding conditions and the resulting asset market prices. Brunnermeier and Pedersen
(2009) model the relationship between market liquidity and funding liquidity. They show that
8

liquidity spirals may occur under certain conditions because market liquidity and funding
liquidity are mutually reinforcing. As stock prices decline significantly, market makers hit their
maintenance margin and are forced to liquidate their existing positions. The liquidation may
cause further decline in stock prices and thus the liquidity spirals. They suggest that liquidity
providers funding would be a driving force for variations in market liquidity. The model
predicts that when the supply of capital tightens, market liquidity declines and the sensitivity of
funding liquidity and market liquidity to market makers capital is larger for risky and illiquid
securities. Limits-to-arbitrage models argue that arbitrageurs face mark-to-market losses as asset
prices decrease (Kyle and Xiong (2001); Xiong (2001)). To maintain their margin requirements,
arbitrageurs liquidate their positions and become liquidity demanders. As the demand for
liquidity increases, trading costs may increase accordingly.
Slow movement of capital plays a significant role in market liquidity and asset pricing
dynamics ( Duffie (2010)). For example, Coval and Stafford (2007) examine asset fire sales in
equity markets and find that a reduction of existing positions by funds experiencing large
outflows creates price pressure in the securities held in common by those distressed funds. Allen
and Gale (2004) model financial fragility and show that small shocks to the demand for liquidity
cause either high asset-price volatility or bank defaults or both. Mitchell, Pedersen, and Pulvino
(2007) provide several examples illustrating how slow moving capital affects asset prices, such
as merger arbitrage, the stock market crash of 1987, and the convertible bond market in 2005
when convertible hedge funds faced large redemptions of capital from investors. They find that
rather than increasing investment levels when prices drop below intrinsic values, arbitrageurs
may, in the face of capital constraints, sell cheap securities causing prices to decline further. In
9

this study, we investigate the impact of slow moving capital and funding liquidity on market
liquidity. Specifically, we hypothesize:
Hypothesis 2: A decline in funding liquidity Granger causes a decline in stock market liquidity
by.
Hypotheses 3: There exists a dynamic relationship between market liquidity and funding
liquidity. (a) The relationship varies across firms and is stronger for the financially distressed
firms. (b) The relationship is stronger during a financial crisis relative to the non-crisis periods.
There is a stream of related literature showing that lower asset prices reduce market
liquidity, and vice versa. Acharya and Pedersen (2005) find that there is a difference between the
highest and lowest liquidity portfolio returns of 4.6 percent per year, of which 3.5 percent is
compensation for expected illiquidity and the remaining 1.1 percent is compensation for liquidity
risk. Korajczyk and Sadka (2008) also find that systematic liquidity is priced in the cross-section
of stock returns. Conversely, Hameed, Kang, and Viswanathan (2010) provide empirical
evidence that negative market returns reduce stock liquidity. However, the samples in the studies
mentioned above are restricted to NYSE ordinary stocks in periods prior to December 2003. In
this study, we examine the deterioration in market liquidity for all stocks during the recent
financial crisis, a time period which really stress tested the hypothesized relationships.
There is indeed a significant time series variation in the level of stock market liquidity.
Chordia, Roll, and Subrahmanyam (2008) document a dramatic increase in liquidity measured by
share turnover in the decade preceding the financial crisis. They find that stocks with larger
levels of institutional holdings experience the greatest increases in turnover. But they do not
study the implication of market makers funding liquidity, which could be an important
determinant of their finding. Anand, et al. (2010), document the opposite trend of liquidity
10

reduction and a significant increase in institutional trading costs during the crisis. They argue
that institutions tend to sell less liquidity-sensitive stocks during the crisis because they would
get a very poor price by selling other stocks that are more sensitive to money supply; the market
liquidity of latter stocks tends to decline when funding liquidity deteriorates.
Although our paper is closely related to Anand, et al. (2010), it is different in the
following ways. First, we extend the analysis to the entire market instead of focusing on a subset
of investors. Second, in our Granger-causality test, we find a unidirectional impact of funding
liquidity on market liquidity, but not the other way around. Third, we examine the dynamic
relationship between funding liquidity and market liquidity in context of the financial crisis,
bailout measures such as TARP, financial versus non-financial firms, and too-big-to fail firms.

3.Data
We use Trades and Automated Quotations (TAQ) dataset to obtain bid price, ask price,
bid depth, ask depth, trade price, and trading volume for each stock time stamped to the seconds.
We use Center for Research in Security Prices (CRSP) data to obtain closing prices and Standard
Industry Classification (SIC) codes. We retain only common stocks (CRSP share codes 10 and
11), which means we exclude securities such as warrants, preferred shares, American Depositary
Receipts, closed-end funds, and REITs. Our sample includes 5,179 stock listed on NYSE,
Nasdaq, and AMEX, which are present in the intersection set of CRSP and TAQ from January
2006 to December 2009.
We obtain the net acquisition of financial assets (NETACQ) by security brokers and dealers from
historical flow of funds accounts of the United States available from the Federal Reserve Boards
11

data archives.
2
To compute TED spreads, we obtain historical 3-month Libor rates at quarterly
and daily frequency from the Wall Street Journal and the Federal Home Loan Bank of Des
Moines, respectively.
3
We obtain historical 3-month Treasury bill rate from the Federal
Reserve.
4
We use Highline Financial database to identify firms that received TARP funding. We
follow Jagtiani and Brewer (2011) to define too-big-to-fail firms as the financial firms that are
one of the 11 largest organizations in each year based on the market capitalization at the end of
the previous year. There are 17 too-big-to-fail firms throughout our sample period.
We compute several measures of liquidity, trading activity, and volatility for every stock.
For each quote update, we determine the best bid (bid) and the best ask (ask) available at the
moment. We use Lee and Ready (1991) without time lag to infer trade direction. Next, we
compute volume-weighted averages of effective spreads and realized spreads, where each trades
weight is the number of shares transacted. We compute time-weighted averages of relative
quoted spread and relative bid depth, where each quotes weight is the time between two
adjacent quotes in seconds. These weighting methods are well established in the market
microstructure literature, for example, see McInish and Wood (1992).
For parsimonious presentation, each measure is first averaged at the daily level separately
for each stock. Each stock-day becomes an observation in our regression dataset. For univariate
reporting, we average the measures across stocks for each day and then average them over all
days within the respective benchmark or treatment periods. We report three different liquidity
measures in percent:
Relative quoted spreads = (100*(ask
t
-bid
t
)/((ask
t
+bid
t
)/2)),

2
http://www.federalreserve.gov/releases/z1/
3
http://www.wsjprimerate.us/libor/libor_rates_history.htm and http://www.fhlbdm.com/rg_history.htm
4
http://www.federalreserve.gov/releases/h15/data.htm
12

Relative effective spreads = (100*I*2*(price

t
-(ask
t
+bid
t
)/2)/((ask
t
+bid
t
)/2), where I=1 for
buyer-initiated trades and I= -1 for seller-initiated trades), and
Relative realized spreads = (100*I*2*(price
t
-( ask
t+5
+ bid
t+5
)/2)/((ask
t+5
+ bid
t+5
)/2), where
t is measured in minutes).
In addition, since the liquidity on the bid side is more important during periods of crisis
due to potential imbalance between buy and sell orders, we also examine relative bid depth
following Diether, Lee, and Werner (2009):
Relative bid depth = (100*(bid depth ask depth)/(bid depth + ask depth))
We also calculate total number of trades, number of shares traded, dollar volume traded,
average trade size, relative price range (days high minus low price, divided by closing price)
and intraday price volatility (in cents) for every stock-day in our sample.
The comparison of liquidity variations during the recent crisis for financial and non-
financial firms entails the creation of a matched sample. Following Bessembinder (2003) and
Huang and Stoll (1996), we match stocks based on five stock characteristics, namely, market
capitalization, price at the beginning of the benchmark period, average dollar trading volume,
average daily number of trades, and average intraday return volatility during the benchmark
period. These stock attributes are closely related to liquidity measures (for examples, see
Demsetz (1968), McInish and Wood (1992), Lin, Sanger, and Booth (1995)).
For each financial stock, we use the following equation to identify the comparable non-
financial stock that has the lowest composite score computed as follows:

2
5
1
( ) / 2
F NF
i i
F NF
i
i i
X X
X X
=


+

13

where X
i
represents one of the five stock characteristics identified above; F and NF refer to
financial and non-financial stocks, respectively. To minimize the initial difference between
financial and non-financial firms, we impose the constraint that the matching score must be less
than 1.5. For our sample of 648 financial stocks (SIC codes from 6000 to 6799), we create a
matched sample of non-financial stocks with replacement.
5


4. Results
4.1. Market liquidity surrounding the financial crisis
In this section, we first investigate the changes in overall market liquidity during the
recent financial crisis. We then explore the changes in market liquidity for financial firms and
their matching non-financial firms. We further differentiate the banks that received TARP
funding. Finally, we partition the financial firms into size quintiles and also separately analyze
the too- big-to-fail firms.
4.1.1. Liquidity measures
We begin by plotting cross-sectional average of effective spread in cents and relative
effective spread in basis points around the crisis period in Figure 1 and Figure 2. We see a
dramatic increase in trading costs during the crisis period accompanied by a decline in S&P 500
index. S&P 500 index fell from peak level of 1565 during the benchmark period to 752 during
the crisis period. We define crisis period as the 4-month period between September 2008
December 2008, a period during which Lehman Brothers went bankrupt and S&P500 index
dropped to a level 52 percent below its previous year high. We define benchmark period as the 4-
month period between September 2007 - December 2007, exactly a year before the crisis period,
when the S&P500 was at the peak level of 1565. Governments around the world started bailing

5
Out of an initial sample of 652 financial firms, we find a match for 648 firms.
14

out distressed firms after the crisis and thus, we defined short-term recovery period as the 4-
month period of January 2009 April 2009, a period during which U.S. government made 351
capital purchases in troubled firms. Finally, we define a long-term recovery period as September
2009 December 2009, a 4-month period, exactly a year after the crisis period, when the
S&P500 recovered to a level of 1,128, or roughly 50 percent higher than the lows of the crisis
period. During this period, Bank of America fully repaid $45 billion of TARP payment that it
had received from the Government, and Citibank repaid $20 Billion of TARP Trust Preferred
Securities.
[Insert Figure 1 and Figure 2 here]
In Table 1, we present summary statistics using time-series average of daily average
liquidity, trading, and volatility measures for each of these periods. In Panel A, we find that all
transaction cost measures are significantly higher during the crisis period compared to the
benchmark period. Relative quoted spread increases from 7.08 basis points in the benchmark
period to 11.67 basis points in the crisis period. Similarly, relative effective spread increases
from 5.97 basis points to 16.34 basis points in the crisis period. These results support Hypothesis
1. Comparing quoted and effective spreads leads to an interesting conclusion about the effects of
crisis on trade executions. During the benchmark period, relative effective spread was lower than
relative quoted spread by 1.11 basis points, implying that more trades executed inside the best
bid and offer quotes (BBO) and fewer trades executed outside the BBO. However, a higher
relative effective spread compared to relative quoted spread during the crisis period implies that
the proportion of trades taking place outside BBO increased significantly, possibly due to
aggressive selling behavior.
15

Comparing quoted and realized spreads help us assess the ex-ante quoting behavior and
the ex-post realized profits of liquidity suppliers. The increased quoted spreads appear to have
passed on to liquidity providers in form of higher relative realized spreads, which increase from
1.61 basis points during the benchmark period to 4.07 basis points during the crisis period. It
appears that liquidity providers become very sensitive to the uncertainty created by the crisis and
conservatively quote wider spreads even though there is no evidence of any increase in adverse
selection costs from trading against more informed traders. Quoted depths also signify the extent
of perceived information asymmetry risk in the market. Liquidity providers were not willing to
undertake the risk of trading in the uncertain environment, especially when the liquidity
providers were on the buy side. Therefore we find a decrease in relative bid depth from 0.40
percent to -0.66 percent during the crisis period.
We observe an improvement in liquidity and a decline in all spread measures both during
the short-term recovery period and the long-term recovery period. During the long-term recovery
period, the relative quoted spread reverts back to its benchmark level while the relative effective
spread is still higher than relative quoted spread. It seems that liquidity demanders are still quite
aggressive and trading quantities beyond the quoted depth during the post crisis periods.
However, when those bargains are available, liquidity providers are willing to exploit them as is
evident from relative bid depths, which revert to 0.50 during long-term recovery, even higher
than levels observed during the benchmark period.
[Insert Table 1 here]
4.1.2. Trading activity and volatility measures
In Table 1 Panel B, we observe an increase in trading activity during the crisis period and
a reversion in trading activity during both short-term and long-term recovery periods. Number of
16

trades increases from 34,040 in the benchmark period to 88,640 in the crisis period, and
subsequently decline to 44,740 during the long-term recovery period. Dollar trading volume
shows a similar pattern of increasing during the crisis and reverting back in the recovery periods.
The increase in the number of trades is consistent with the aggressive selling behavior reflected
by the higher relative effective spread compared to the relative quoted spread during the crisis
period. Trade size is significantly lower during the crisis period at 190.89 shares compared to
247.91 shares during the benchmark period or 239.81 shares during the long-term recovery
period. The reason that traders are trading only small quantities might be due to the difficulty in
asset valuation during the crisis. The reduction in the trade size also suggests that liquidity
providers are reluctant to quote larger quantities even though they have increased the quoted
spread. In Panel C, both price volatility and relative price range are higher during the crisis
period and decline during the short-term and the long-term recovery periods. Relative price
range increases from 2.76 percent during the benchmark period to 7.04 percent in the crisis
period. It reverts back to 2.66 percent during the long-term recovery period. Price volatility in
cents shows a similar trend; it increases during the crisis periods and drops back during the long-
term recovery period.
4.1.3. Financial versus non-financial firms
In this section, we compare 648 financial stocks with their matched sample. Figure 3
shows that trading costs are at similar levels for financial firms and matched non-financial firms
during the benchmark period. Although trading costs increase for all firms during the financial
crisis, the increase is much higher for the financial firms.
[Insert Figure 3 here]
17

We calculate the average difference in liquidity, trading activity, and volatility measures
between each financial firm and its corresponding matched non-financial firm and present the
respective time-series average of these differences for each period in Table 2. In Panel A, the
difference in the relative quoted spread between financial and non-financial firms is insignificant
during the benchmark period. The magnitude of this difference increases to a significant 3.04
basis points during the crisis period. The increase is somewhat permanent with no signs of
reversal even in the long-term recovery period, where the difference is 1.91 basis points. The
relative effective spread and the relative realized spread show similarly increasing trends during
and after the crisis.
Liquidity providers respond to uncertain valuation environment both by widening spreads
and by reducing depths. Lee, Mucklow, and Ready (1993) find that liquidity providers change
both spreads and depth in response to information asymmetry. Spreads increase and depths
decline in response to high volume during times of information asymmetry. In our sample, the
financial stocks generally have much higher relative bid depths than the non-financial stocks in
the benchmark period. Relative bid depth is significantly lower for the financial stocks during the
crisis period as the difference between financial and non-financial firms is -1.48 percent. In the
long-term recovery period, the difference in relative bid depth is -0.44 percent. A negative
number means that ask depth was greater than the bid depth. It seems that liquidity providers are
not nearly as comfortable buying the financial stocks during the crisis period as they are during
normal periods.
[Insert Table 2 here]
In Table 2, Panel B, we find that the number of trades is higher by 6,290 per day for the
financial firms. This difference increases ten folds to 67,200 during the crisis period and keeps
18

increasing during the short-term recovery period, but reverts back during the long-term recovery
period to 34,470. We see similar patterns for the number of shares traded and the dollar volume
traded. The difference in trade size continues to increase throughout the crisis and recovery
periods. Higher trade size for the financial firms indicates that market participants are more
aggressive in selling the financial stocks as compared to the non-financial stocks.
In Table 2 Panel C, we note that the difference in price volatility of financial versus non-
financial stocks increases from 0.019 during the pre-crisis benchmark period to 0.159 during the
crisis period. The difference in price volatility reverts during the long-term recovery period to
0.034. The difference in relative price range also increases from 0.40 percent to 3.53 percent
during the crisis period and declines to 2.56 percent during the long-term recovery period.
In summary, all of our liquidity measures deteriorate more dramatically for the financial
stocks than for the non-financial stocks.
4.1.4. Troubled versus non-troubled firms and financial firms of different sizes
In this section, we compare banks that received TARP funding (troubled firms hereafter)
with firms that did not receive TARP funding (non-troubled firms hereafter). In Table 3 Panel A,
we find that the relative effective spread increases by 14 basis points for the troubled firms
during the crisis period. For the non-troubled firms, the increase in the relative effective spread
during the same period is lower at 10 basis points. While the relative effective spread keeps
increasing for the troubled firms during the short-term recovery period, the relative effective
spread of the non-troubled firms declines during this period. Thus, the TARP funding by the U.S.
government did not immediately help in improving the liquidity of the troubled firms. The
results are similar for the number of trades and the relative price range. For the troubled firms,
the number of trades and the relative price range increase by 167,280 and 7.09 during the crisis
19

period, compared to an increase of 46,350 and 4.08 for the non-troubled firms. The number of
trades and relative price range keep increasing by 60,190 and 1.48 percent, respectively, for the
troubled firms during short-term recovery period. For the non-troubled firms, we find a decrease
in both numbers. The number of trades decreases by 12,120 and the relative price range
decreases by 2.28 percent. Thus, the market continued to interpret TARP funding as a sign of
much deeper trouble at the TARP recipient firms, even as it regained confidence about the
viability of the non-TARP firms. In the long-term recovery period, both sets of firms recovered;
the relative effective spread declines by 9 basis points for the troubled firms and 8 basis points
for the non-troubled firms, from the peak levels during the crisis period. Also in the long-term,
there is a decline in volatility and trading activity for both troubled and non-troubled firms.
Although the immediate effect of the bailout measures was in the opposite directions for the
troubled firms compared to the non-troubled firms, in the long run, the liquidity of both troubled
and non-troubled firms improved.
[Insert Table 3 here]
Popular press had also advocated that firms which represented systemic risk to the
financial system were considered too big to fail and were the primary targets of government
intervention and support. Therefore, we separately analyze financial stocks of varying sizes in
Table 3 Panel B. We make quintiles of all financial stocks in our sample based on market
capitalization at the end of previous year. Jagtiani and Brewer (2011) define too-big-to-fail firms
as the financial firms that are one of the 11 largest organizations in each year based on the
market capitalization at the end of the previous year. During our sample period, the list of too-
big-to fail firms comprises of 17 unique firms. Some firms such as Citibank and Bank of
America are part of our too-big-to-fail list throughout our sample period, while firms like Merrill
20

Lynch and Wachovia Bank drop out of our sample in 2008 and 2009.
6
We focus our analysis on
quintile 1 (small firms), quintile 5 (large firms), and too-big-to-fail firms. Since we are studying
time-series variation in liquidity of these too-big-to-fail firms, we keep all 17 firms in our sample
for each period, when available.
The relative quoted spread increases during the crisis period for financial firms in all
quintiles and it reverts back in the long-term recovery period. We observe the highest increase of
72 basis points for small firms and the lowest increase of 3 basis points for too-big-to-fail firms.
In the long-term recovery period, this difference reverts back by 33 basis points and 1 basis point
for small firms and too-big-to-fail firms, respectively. We see a similar trend in the relative
effective spread. The number of trades increases for firms in all three categories. For too-big-to-
fail firms, the number of trades increases by 186,090 and for small firms, by 100. We see a
pronounced decrease of 134,260 in the number of trades for too-big-to-fail firms during the long-
term recovery period. The increase in the relative price range during the crisis period for small
and large firms is 4.32 percent and 7.20 percent, respectively, while for too-big-to-fail firms the
increase is 7.18 percent. Thus, these too-big-to-fail firms are as volatile as other large financial
firms during the crisis period. The reversion in price volatility is 4.28 percent for too-big-to-fail
firms compared to 5.76 percent for other large firms.
In summary, transaction costs increase more for small firms but volatility and trading
activity increase more for big and too-big-to-fail financial firms.
4.2. Impact of firm-specific and market-wide returns on transaction costs
In this section, we identify the determinants of a firms stock market liquidity,
specifically in the periods of declining stock prices. In our regression analysis with firm-specific

6
Out of 17 too-big-to-fail firms, the following 5 firms overlap with our list of troubled firms: Bank of America,
Bank of New York Mellon Corporation, Citibank , U.S. Bancorp, and Wells Fargo & Company.
21

liquidity as the dependent variable, the key explanatory variables include market-wide return and
firm-specific return closely following the methodology used by Hameed, Wang and Viswanathan
(2010):
SPR
,t
= o

+ [
,k
R
m,t-k
4
k=1
+ y
,k
R
,t-k
4
k=1
+c
1
SI
m,t
+c
2
SI
,t
+c
3
SI
m,t-1
+c
4
SI
,t-1
+c
5
IuRN
,t-1
+c
6
R0IB
,t-1
+
,k
SPR
,t-k
4
k=1
+e
,t

where SPR
i,t
is the weekly average of firm is daily relative quoted spread in week t. SPR
i,t
is
the change in spreads relative to previous week. Our main variables of interest are lagged market
return (R
m,t-k
) and lagged firm-specific stock return (R
i,t-k
). We proxy R
m,t-k
by the CRSP value-
weighted return. We use 4 lags of market return and 4 lags of firm-specific returns. Other control
variables are defined as follows. STD
m,t
and STD
i,t
represent changes in volatilities of market
returns and stock returns estimated using daily returns over the previous 4 weeks according to
the method used in French, Schwert, and Stambaugh (1987). TURN
i,t
represents weekly
changes in turnover, measured as the total weekly share volume traded for firm i divided by its
shares outstanding. ROIB
it
represents weekly changes in relative order imbalance standardized
by the total dollar volume traded during that period. Relative order imbalance is weekly
difference in the dollar amount of buyer initiated trades and seller initiated trades.
We run a time-series regression for each stock separately and then report mean and
median of the estimated regression coefficients across all firms in our sample in Table 4 Panel A.
The coefficients on the return variables are consistent with Hameed, Wang and Viswanathan
(2010) who focus on the period before the financial crisis. The lagged market returns in each of
the past 3 weeks negatively affect current changes in spreads, with the effects declining till lag 3.
The effect of market return reverses sign for the 4
th
lag. Stock returns have a monotonically
22

decreasing and significant relationship with current changes in spreads. Therefore, we conclude
that decline in market returns and stock returns increase spreads and reduce stock liquidity.
[Insert Table 4 here]
Since the recent financial crisis may represent a structural break in these relationships, we
allow spreads to react differentially to lagged market returns during the crisis period.
Furthermore, we allow spreads to react differentially to positive and negative lagged stock
returns and run the following regression:
SPR
,t
= o

+ [
,k
R
m,t-k
4
k=1
+ [
css,,k
R
m,t-k
4
k=1
- crisis + y
,k
R
,t-k
4
k=1
+ y
0wN,,k
R
,t-k

own,,t-k
4
k=1
+c
1
SI
m,t
+c
2
SI
,t
+c
3
SI
m,t-1
+c
4
SI
,t-1
+c
5
IuRN
,t-1
+c
6
R0IB
,t-1
+
,k
SPR
,t-k
4
k=1
+e
,t

where D
Down,i,t
is a dummy variable indicating negative returns and we set it equal to one if and
only if R
i,t
is less than zero. Crisis is a dummy variable that is equal to 1 for the 4-month period
of September December 2008, and 0 otherwise. The product terms represent interactive
variables. Other variables retain their definitions from the previous equation. We report the
results of this regression in Table 4 Panel B. When we sum the coefficients for R
m,t-1
and R
m,t-1
*
crisis, the impact of lagged market return changes from -0.36 during the non-crisis period to -
0.81 during the crisis period, implying a higher impact on spreads. In summary, lagged negative
market returns causes the spreads to widen more during periods of the financial crisis.
4.3. Effects of funding liquidity on market liquidity
Next, we examine the joint impact of declining funding liquidity and negative market
returns during the crisis period on changes in spreads. We use a dummy variable for high versus
low funding liquidity. We also employ a simultaneous system of equations approach.
23

We define D
CAP,t
as a dummy variable that equals 1 if week t is a period of lower funding
liquidity compared to week t-1 and 0 otherwise. We use the TED spread as a measure of funding
liquidity. For example, if the TED spread increases from 1.10 percent to 1.15 percent during a
week, we assign D
CAP,t
a value of 1 for that week. We add this variable to our regression
equation to obtain the following model:
SPR
,t
= o

+ [
,k
R
m,t-k
4
k=1
+ [
css,,k
R
m,t-k
- crisis
4
k=1

+ [
css,CAP.,1
R
m,t-1
- crisis -
CAP,t-1
+ y
,k
R
,t-k
4
k=1

+ y
0wN,k
R
,t-k

own,,t-k
4
k=1
+c
1
SI
m,t
+c
2
SI
,t
+c
3
SI
m,t-1
+c
4
SI
,t-1
+c
5
IuRN
,t-1
+c
6
R0IB
,t-1
+
,k
SPR
,t-k
4
k=1
+e
,t

We report the results of this regression in Table 4 Panel C.
We find that market-wide price declines lead to a particularly greater increase in the
relative quoted spread during times of declining funding liquidity. The coefficient of -0.36 on
R
m,t-1
suggests that the relative quoted spreads increase by 36 basis points when market declines
by 1 percent during normal periods. This effect is more acute during the crisis period. In
particular, when we sum the coefficients for R
m,t-1,
R
m,t-1
* crisis, and R
m,t-1
* crisis * D
CAP,t-1
, we
find that the impact of lagged market return changes from -0.36 during the normal period to -
0.88 during the crisis period when there is a simultaneous decline in funding liquidity. Thus, we
find evidence that liquidity dry-ups during the recent financial crisis were stronger during
periods of a simultaneous decline in both market returns and funding liquidity.
Next, for the recent crisis period, we test the Brunnermeier and Pedersen (2009) model
that links funding liquidity to market liquidity. Our dependent variable is the relative effective
spread of stocks averaged over each quarter in our sample period. We capture the funding
24

liquidity by considering a direct measure NETACQ, which is the net acquisition of financial
assets by security brokers and dealers. We also consider the TED spread as a measure of funding
liquidity used by previous studies (e.g., Anand, et al. (2010)). The TED spread is the difference
between the LIBOR (London Interbank Offered Rate) and the U.S. Treasury bill rate. The TED
spread increases from 1.25 percent in October 2007 to 3.39 percent in October 2008.
Brunnermeier and Pederson (2009) note that the TED spread widens during the financial crisis
because of two reasons. In times of uncertainty, banks charge higher interest for unsecured loans,
which increases the LIBOR rate. Further, Treasury bonds become more attractive for banks as
first rate collaterals, pushing down the Treasury bond rate. Thus, higher TED spread causes a
decrease in funding liquidity. Following McInish and Wood (1992), we control for other widely
used determinants of trading costs, such as market capitalization, dollar trading volume, and
volatility.
We further employ an additional proxy for funding liquidity and estimate the following
two-stage equations:
Stage 1: Net acquisition of financial assets = f(TED spread, T-bill rate) + u
Stage 2: Relative effective spread = f(TED spread, market capitalization, dollar trading
volume, volatility, u) +
In stage 1, we orthogonalize net acquisition of financial assets by security brokers and
dealers (in billion dollars) at quarterly frequency. We run a regression of net acquisition of
financial assets on the TED spread and the T-bill rate and store the regression residuals. Then in
stage 2, we capture the incremental explanatory power of this funding liquidity variable by using
the residuals as an independent variable. This orthogonalization process also ensures that the
assumption of independence required in the OLS regression framework is satisfied. We report
25

the results of these regressions in Table 5. Stage 1 estimates are in Panel A and stage 2 estimates
are in Panel B.
[Insert Table 5 here]
We use three models for the second stage regression. In model 1, we regress the relative
effective spread on the cost of funding capital alone. The proxy for the cost of funding capital is
the contemporaneous TED spread. We find a positive relationship between relative effective
spread and the TED spread. An increase of 1 percent in TED spread on average increases relative
effective spread of a stock by about 17 basis points. Therefore stock market liquidity declines
when liquidity providers face higher funding costs.
In model 2, we add control variables including volatility, firm size, and trading volume
averaged over each quarter. We find that trading costs are lower for high market capitalization
stocks and stocks with higher dollar trading volume. An increase in volatility is related to an
increase in trading cost. In model 3, we also include the residuals from the regression in Table 5
Panel A as an independent variable to capture funding liquidity unexplained by the TED spread.
We find that the coefficient of the residuals is negative and significant. The higher the levels of
funding liquidity, the lower are the spreads. Thus, the coefficient suggests a positive relation
between funding liquidity and market liquidity. A 100 billion dollar acquisition (sale) of
financial assets which is unexplained by increase in the TED spread causes the relative effective
spread to decrease (increase) by 0.36 basis points.
4.4. Granger causality test
We further explore the direction of causality between funding liquidity and stock market
liquidity using the Granger causality test (Granger, 1969).This analysis tests the condition that
26

changes in the causal variables should precede changes in the affected variables. The model
specifications are as follows:
Market liquidity
t
=

0
+
1
Funding liquidity
t-1
+
2
Market liquidity
t-1
+ Control variables +
t

Funding liquidity
t
=

0
+
1
Funding liquidity
t-1
+
2
Market liquidity
t-1
+ Control variables +
t
We use the TED spread as a measure of funding liquidity and the relative effective spread
as a measure of market liquidity. If both
1
0 and
2
0, we would infer an endogenous bi-
directional relationship between funding liquidity and market liquidity. If
1
0 but
2
= 0, it is
more likely that funding liquidity affects market liquidity. If
1
= 0 but
2
0, it is more likely
that the market liquidity affects funding liquidity. If both
1
= 0 and
2
= 0, funding liquidity has
no causal relation with market liquidity. We control for T-bill rate, log (market capitalization),
and log (dollar trading volume). We report the Granger causality test results in Table 6.
[Insert Table 6 here]
We find that
1
is positive and significant, and
2
is insignificant. These findings reveal a
uni-directional causality from funding liquidity to market liquidity and support our Hypothesis 2.
4.5. Dynamic relationship between funding liquidity and market liquidity
In this section, we use higher frequency daily data to study the dynamic relationship
between a stocks relative effective spread and the TED spread. At quarterly frequency, the TED
spread reaches a peak value of 2.43 percent during the last quarter of 2008, while the daily TED
spread captures full variation of TED spread from a low of 1.53 percent to a high of 4.58 percent
during the same period. We run a pooled regression of stock-level liquidity on funding liquidity
and report the coefficient estimates in Table 7. In model 1, we confirm a positive relationship
between funding liquidity and market liquidity. An increase in the TED spread of 1 percent is
associated with an increase of 8.65 basis points in the relative effective spread. In model 2, we
27

also include control variables such as volatility, firm size, and trading volume. We find a similar
positive relationship between funding liquidity and market liquidity. In model 3, we only include
firms that received TARP funding. We further interact the TED spread with the TARP event:
TED * before Tarp event, where before TARP event takes a value of 1 before the TARP issue
date, and 0 otherwise, and TED * after Tarp event, where after Tarp event takes a value of 1 after
the TARP issue date, and 0 otherwise. The coefficient of TED * after Tarp event 0.4752 as
compared to coefficient of TED * before Tarp event, which is 0.1416. The signs and relative
magnitudes of these coefficients suggest that the relationship is stronger for these troubled firms
than non-troubled firms and it becomes even stronger after the announcement of TARP. In
model 4, we include two interactive variables for financial and non-financial firms; TED *
financial, where financial takes a value of 1 for all financial firms, and 0 otherwise, and TED *
non-financial, where non-financial takes a value of 1 for all non-financial firms, and 0 otherwise.
The coefficient of TED * financial is 0.0943 as compared to coefficient of TED * non-financial,
which is 0.0918. Thus, we find that the relationship is stronger for the financial firms. In model 5,
we include two interactive variables, one for too-big-to-fail firms and one for firms which are not
too-big-to fail firms as follows; TED * too-big-to-fail, where too-big-to-fail takes a value of 1 for
11 largest financial firms during each year based on the market capitalization, and 0 otherwise,
and TED * not too-big-to-fail, where not too-big-to-fail takes a value of 1 for all firms that are
not categorized as too-big-to-fail, and 0 otherwise. The coefficient of TED * too-big-to-fail is
0.6207 as compared to coefficient of TED * not too-big-to-fail, which is 0.0904. Therefore the
stock liquidity of too-big-to-fail firms is more sensitive to changes in funding capital.
Collectively regression results from models 1 through 5 supports Hypothesis 3a. In model 6, we
include two interactive variables for crisis period and non-crisis period; TED * crisis, where
28

crisis takes a value of 1 for the period September-December of 2008, and 0 otherwise, and TED
* non-crisis, where non-crisis takes a value of 1 for the period excluding September-December
of 2008. The coefficient of TED * crisis is 0.1215 as compared to coefficient of TED * non-
crisis, which is 0.0175. These results show a stronger relationship between funding liquidity and
market liquidity during the crisis period. In model 7, we re-confirm this finding by excluding the
crisis period from our sample. After excluding the crisis period, we find that the relationship is
still positive, but the coefficient has declined from 0.0922 in model 2 including the crisis period
to 0.0155 in this model excluding the crisis period. Therefore the financial crisis elevates the
importance of funding liquidity for equity market makers liquidity provision functions. These
results support Hypothesis 3b.
[Insert Table 7 here]

5. Conclusion
In this paper, we analyze the dynamic nature of the relationship between funding liquidity,
stock market liquidity, trading activity, and volatility. Our analysis periods include a benchmark
period, the recent financial crisis period, a short-term recovery period, and a long-term recovery
period. We also study the variations among financial versus non-financial firms, troubled versus
non-troubled firms, small versus large firms, and too-big-to fail firms.
Although trading activity intensifies during the financial crisis period, stock market
liquidity deteriorates and prices become more volatile. The relative effective spread increases
almost three-fold from 5.97 basis points in the benchmark period to 16.34 basis points during the
crisis. Average intra-day price volatility increases from 0.33 cents in the benchmark period to
0.56 cents during the crisis. We examine the immediate and the long-term improvements in
29

market liquidity in response to capital injections, credit easing, and other policy changes targeted
at resolving the financial crisis. The relative effective spread declines to 13.33 basis points
immediately following the bailouts such as TARP. While bailouts appear to have prevented a
further deterioration in liquidity, trading costs during the bailout period continue to be twice of
their benchmark levels. The relative effective spread during the long-term recovery period is
8.57 basis points, indicating that trading costs are restored back almost to their pre-crisis levels
within one year of the peak of the financial crisis. Similarly, volatility more than doubles during
the crisis period but is restored back to its pre-crisis level a year after the crisis.
We separately analyze troubled firms that received TARP funding and non-troubled firms
that did not receive TARP funding. We find that the troubled firms have a much higher
deterioration in stock liquidity during the crisis period compared to the non-troubled firms.
Similarly, there is a much higher surge in trading activity for these troubled firms compared to
the non-troubled firms. Volatility spike is also more remarkable for the troubled firms. Next, we
look at the size quintiles of financial firms and find that liquidity declines significantly in all
quintiles. The liquidity in the small stocks was hit the hardest. The relative effective spread for
the small stocks increases by 75 basis points while the increase for too-big-to-fail firms is only
10 basis points. Too-big-to-fail firms do not suffer as much in terms of liquidity perhaps
because of their legacy brand image and a higher level of liquidity before the onset of the
financial crisis. In response to the financial crisis, the Senate Banking Committee passed Senator
Christopher Dodds Financial Overhaul Bill that proposes to create a council to detect systemic
risk to the financial system, and trigger, if necessary, a process to seize and dismantle a large
financial firm on the verge of failure.
30

When comparing financial firms with matched non-financial firms, we find that liquidity
declines in the financial stocks are more severe. Furthermore even one year after the financial
crisis, liquidity didnt normalize for the financial stocks even though it was restored to the pre-
crisis levels for the non-financial stocks. Financial stocks continue to suffer from trading costs
much higher than matched sample of non-financial firms.
We extend the literature studying the impact of market returns and stock returns on stock
market liquidity during the recent financial crisis. We find that both lagged market returns and
lagged stock returns play a role in determining stock liquidity. While, negative market return and
negative stock return worsen future stock liquidity, positive returns improve future liquidity. We
also find that this relationship during the crisis becomes stronger when negative market return is
accompanied by a decline in funding liquidity. To understand the genesis of these relationships,
we examine the impact of funding constraints of liquidity providers on stock market liquidity. If
liquidity providers approach their funding limits, they may discontinue their liquidity supply
function and instead demand liquidity through aggressive selling. In Granger causality tests, we
find a uni-directional relationship where funding liquidity affects stock market liquidity. When
liquidity providers face critical levels of funding constraints, we observe a severe decline in
stock market liquidity, but not vice-versa.
We also study the dynamics of the relationship between funding liquidity and stock
market liquidity. We find that the relationship is much sharper during the crisis period. For the
troubled firms, this relationship is tighter, particularly after the announcement of TARP. The
relationship between funding and market liquidity is always stronger for the financial firms than
for the non-financial firms, and is the strongest for the too-big-to fail firms. In summary, our
results indicate that massive amounts of funding liquidity injected by the FED following the
31

financial crisis played a major role in restoring stock market liquidity to the pre-crisis levels.
32

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34

Figure 1: Effective spread from September 2007-December 2009
We take cross-sectional value-weighted average of effective spread in cents for all NYSE,
Nasdaq, and AMEX-listed stocks for each day during the period September 2007 December
2009. Effective spread is defined as the signed difference between the trade price and the quote
mid-point at the time of the trade. We plot the numbers in the figure above using the vertical
scale on the left. We also plot daily closing S&P 500 Index using the vertical scale on the right.
We define crisis period as the 4-month period from September 2008 December 2008.










E
f
f
e
c
t
i
v
e

s
p
r
e
a
d

i
n

c
e
n
t
s

S
&
P

5
0
0

I
n
d
e
x

35

Figure 2: Relative Effective spread from September 2007-December 2009
We take cross-sectional value-weighted average of relative effective spread in basis points for
all NYSE, Nasdaq, and AMEX-listed stocks for each day during the period September 2007
December 2009. Relative effective spread is defined as the signed difference between the trade
price and the quote mid-point at the time of the trade divided by the quote mid-point. We plot the
numbers in the figure above using the vertical scale on the left. We also plot daily closing S&P
500 Index using the vertical scale on the right. We define crisis period as the 4-month period
from September 2008 December 2008.


S
&
P

5
0
0

I
n
d
e
x

R
e
l
a
t
i
v
e

e
f
f
e
c
t
i
v
e

s
p
r
e
a
d

36

Figure 3: Trading cost of financial stocks vs. matched non-financial stocks
We define benchmark period as September 2007 - December 2007; Crisis period as September
2008 December 2008; Short-term recovery period as January 2009 April 2009; and long-term
recovery period as September 2009 December 2009. For 648 financial stocks (SIC codes from
6000 to 6799) listed on NYSE, Nasdaq, and AMEX, we create a matched sample of non-
financial stocks during benchmark period. Our matching criteria minimizes the difference
between market capitalization, price, average dollar trading volume, average daily number of
trades, and average intraday return volatility of financial firms and matched non-financial firms.
For each period, we take time-series average of daily relative effective spread averaged across
stocks, separately for financial stocks and matched non-financial stocks.

37

Table 1
Descriptive statistics
The summary statistics represent a panel of trading data for 5,179 common stocks listed on NYSE,
Nasdaq, and AMEX which are in the intersection set of Center for Research in Security Prices (CRSP)
tapes and the Trade and Automated Quotations (TAQ). We define benchmark period as September 2007 -
December 2007; Crisis period as September 2008 December 2008; Short-term recovery period as
January 2009 April 2009; and long-term recovery period as September 2009 December 2009. We
report liquidity measures for each period as follows. Mid-quote is the average of the best bid and best ask
price. Relative quoted spread is defined in percent as 100*(ask price bid price)/ mid-quote. Relative
effective spread is defined in percent as 100*2*|Traded price mid-quote|/mid-quote. Relative realized
spread is defined in percent as 100*2*(Price
t
mid-quote
t+5
)/ mid-quote
t+5
for buys and
100*2*(Midquote
t+5
-price
t
)/ mid-quote
t+5
for sells where trades are matched to quotes in force 5 minutes
following the trade. Relative bid-depth is defined in percent as 100*(bid depth - ask depth)/(ask depth +
bid depth). In Panel B, we report number of trades, dollar volume traded, number of block trades (trade
size > 10,000 shares), and average trade size in number of shares. In Panel C, we report volatility
measures. Relative price range is the intraday highest price minus the lowest price divided by the closing
price and price volatility is calculated as the standard deviation of intraday trade prices in cents. Numbers
in parentheses represent differences, the formulas for which are shown in the top row header of the table.

Benchmark Crisis
(Crisis -
Benchmark)
Short-term recovery
(Short-term recovery -
Crisis)
Long-term recovery
(Long-term recovery -
Crisis)

Panel A: Liquidity measures

Relative quoted Spread 0.0708 0.1167 0.1015 0.0695
(0.0459 ***) (-0.0151 ***) (-0.0472 ***)
Relative effective spread 0.0597 0.1634 0.1333 0.0857
(0.1037 ***) (-0.0302 ***) (-0.0777 ***)
Relative realized spread 0.0161 0.0407 0.0314 0.0224
(0.0246 ***) (-0.0093 ***) (-0.0182 ***)
Relative bid depth 0.3988 -0.6584 0.2122 0.4956
(-1.0572 ***) (0.8706 ***) (1.1540 ***)
Panel B: Trade activity measures
N Trades (In '000) 34.04 88.64 76.57 44.74
(54.60 ***) (-12.06 ***) (-43.90 ***)
$ Volume traded (In '000) 535,315 699,105 555,901 478,333
(163,790 ***) (-143,204 ***) (-220,772 ***)
Trade size 247.91 190.89 197.89 239.81
(-57.03 ***) (7.00 ***) (48.92 ***)
Panel C: Volatility measures
Relative price range (%) 2.76 7.04 4.86 2.66
(4.29 ***) (-2.19 ***) (-4.38 ***)
Price volatility 0.33 0.56 0.34 0.23
(0.23 ***) (-0.22 ***) (-0.34 ***)
***, ** and * represent significance at 1%, 5% and 10% respectively.
38

Table 2
Descriptive statistics for financial stocks vs. matched non-financial stocks
The summary statistics represent the time-series average of the cross-sectional paired differences
between each financial firm and the matched non-financial firm for each period. We use a sample of 648
financial stocks and 648 matched non-financial stocks listed on NYSE, Nasdaq and AMEX. The included
stock-days are required to have data available on both Center for Research in Security Prices (CRSP)
tapes and the Trade and Automated Quotations (TAQ). We define benchmark period as September 2007 -
December 2007; Crisis period as September 2008 December 2008; Short-term recovery period as
January 2009 April 2009; and long-term recovery period as September 2009 December 2009. Mid-
quote is the average of the best bid and best ask price. Relative quoted spread is defined in percent as
100*(ask price bid price)/ mid-quote. Relative effective spread is defined in percent as 100*2*|Traded
price mid-quote|/mid-quote. Relative realized spread is defined in percent as 100*2*(Price
t
mid-
quote
t+5
)/ mid-quote
t+5
for buys and 100*2*(Midquote
t+5
-price
t
)/ mid-quote
t+5
for sells where trades are
matched to quotes in force 5 minutes following the trade. Relative bid-depth is defined in percent as
100*(bid-depth - ask-depth)/(ask-depth + bid-depth). In Panel B, we report number of trades, dollar
volume traded, number of block trades (size > 10,000), and average trade size in number of shares. In
Panel C, we report volatility measures. Relative price range is the intraday highest price minus the lowest
price divided by the closing price and price volatility is calculated as the standard deviation of intraday
trade prices in cents.
Financial Minus non-Financial firms
Period
Benchmark Crisis
Short-term
recovery
Long-term
recovery
Panel A: Liquidity measures

Relative quoted Spread 0.0006 0.0304 *** 0.0195 ** 0.0191 ***
Relative effective spread 0.0032 *** 0.0582 *** 0.0384 *** 0.0206 ***
Relative realized spread 0.0026 *** 0.0120 *** 0.0064 ** 0.0033 *
Relative bid depth 0.4478 ** -1.4845 *** -0.1896 -0.4398 ***
Panel B: Trading activity measures
N Trades (In '000) 6.29*** 67.20*** 97.07*** 34.47***
$ Volume traded (In '000) -562.42 207,052*** 365,365*** 269,108***
Trade size -10.96*** 17.93*** 41.86*** 153.44***
Panel C: Volatility measures
Relative price range (%) 0.40*** 3.53*** 4.36*** 2.56***
Price volatility 0.019*** 0.159*** 0.151*** 0.034***
***, ** and * represent significance at 1%, 5% and 10% respectively.



39

Table 3
Descriptive statistics for troubled firms vs. non-troubled firms and for financial firms by size
In Panel A, the summary statistics represent the time-series averages of the cross-sectional statistics,
separately for firms which received tarp funding and firms which did not receive tarp funding. The
included stock-days are required to have data available in both Center for Research in Security Prices
(CRSP) tapes and the Trade and Automated Quotations (TAQ). We define benchmark period as
September 2007 - December 2007; Crisis period as September 2008 December 2008; Short-term
recovery period as January April 2009; and long-term recovery period as September 2009 December
2009. Mid-quote is the average of the best bid and best ask price. Relative quoted spread is defined in
percent as 100*(ask price bid price)/ mid-quote. Relative effective spread is defined in percent as
100*2*|Traded price mid-quote|/mid-quote. We also report number of trades, and relative price range.
Relative price range is the intraday highest price minus the lowest price divided by the closing price.
Panel B reports summary statistics by firm size. We sort all financial firms into quintiles based on the
market capitalization of each firm. Following Jagtiani and Brewer (2011), we define too-big-to-fail
firms as the 11 largest firms at the end of each year based on their market capitalization.
Crisis
Benchmark
Short-term
recovery
Crisis
Long-term
recovery Crisis
Panel A: Troubled vs. non-troubled firms
Relative quoted spread Troubled firms 0.06*** 0.02*** -0.03***
Non-troubled firms 0.04*** -0.02*** -0.05***
Relative effective spread Troubled firms 0.14*** 0.01 -0.09***
Non-troubled firms 0.10*** -0.03*** -0.08***
N Trades (In '000) Troubled firms 167.28*** 60.19*** -106.48***
Non-troubled firms 46.35*** -12.12*** -39.44***
Relative price range (%) Troubled firms 7.09*** 1.48 -3.54
Non-troubled firms 4.08*** -2.28*** -4.43***
Panel B: Firms by size quintiles and too-big-to-fail firms
Relative quoted spread Quintile 1 (small) 0.72*** 0.17*** -0.33***
Quintile 5 (large) 0.06*** 0.00 -0.05***
Too big to fail 0.03*** 0.02*** -0.01***
Relative effective spread Quintile 1 (small) 0.75*** 0.45*** -0.20***
Quintile 5 (large) 0.14*** -0.02** -0.10***
Too big to fail 0.11*** 0.00 -0.07***
N Trades (In '000) Quintile 1 (small) 0.10*** -0.02 0.06**
Quintile 5 (large) 105.01*** 8.37 -72.59***
Too big to fail 186.09*** 33.22** -134.26***
Relative price range (%) Quintile 1 (small) 4.32*** 2.41*** -1.74***
Quintile 5 (large) 7.20*** -1.55* -5.76***
Too big to fail 7.18*** 0.13 -4.28
***, ** and * represent significance at 1%, 5% and 10% respectively.
40

Table 4
Spreads, returns, and, impact of the funding constraints
We estimate the following regression equation following Hameed, Wang and Viswanathan (2010):
SPR
,t
= o

+ [
,k
R
m,t-k
4
k=1
+ y
,k
R
,t-k
4
k=1
+ control :orioblcs + e
,t

We run the time-series regression for each stock and report the mean and median of the estimated regression coefficients across all firms in our
sample in Panel A. SPR
i,t
is the average of firm is daily relative quoted spread in week t. SPR
i,t
is the change in weekly spreads. Our main
variables of interest are lagged market return (R
m,t-k
) and lagged stock return (R
i,t-k
). We proxy R
m,t-k
by the CRSP value-weighted return. The firm-
specific weekly control variables are: turnover (TURN
i,t
); relative order imbalance (ROIB
i,t
); and idiosyncratic volatility (STD
i,t
) and volatility of
the market return in week t (STD
m,t
). Similarly, in Panel B we report the mean and median of the estimated regression coefficients across all stocks
from the following regression:
SPR
,t
= o

+ [
,k
R
m,t-k
4
k=1
+ [
css,,k
R
m,t-k
- crisis
4
k=1
+ y
,k
R
,t-k
4
k=1
+ y
0wN,,k
R
,t-k

own,,t-k
4
k=1
+ control :orioblcs + e
,t


D
Down,i,t
is a dummy variable indicating negative returns and we set it equal to one if and only if R
i,t
is less than zero. Crisis is a dummy variable
that is equal to one for the period from September 2008 December 2008.

Next, in Panel C we report the mean and median of the estimated regression coefficients across all stocks from the following regression:
SPR
,t
= o

+ [
,k
R
m,t-k
4
k=1
+ [
css,,k
R
m,t-k
- crisis
4
k=1
+ [
css,CAP.,1
R
m,t-1
- crisis -
CAP,t-1
+control :orioblcs + e
,t


D
CAP,t
is a dummy variable that takes a value of one only if week t is associated with periods of lower funding liquidity compared to week t-1.
Panel A: Spreads and lagged returns
Estimated Coefficients R
m,t-1
R
m,t-2
R
m,t-3
R
m,t-4
R
i,t-1
R
i,t-2
R
i,t-3
R
i,t-4

Mean -0.5207*** -0.3363*** -0.0378*** 0.1232*** -0.0737*** -0.0622*** -0.0441*** -0.0447***
Median -0.3107 -0.2145 -0.0041 0.0948 -0.0572 -0.0438 -0.0335 -0.0354

Estimated Coefficients STD

m,t-1
STD
i,t-1
Turn
i,t-1
OIB
i,t-1
STD
m,t
STD
i,t

Mean 0.0166 -0.0070 0.0000 0.0068*** 0.1969*** 0.0366***
Median 0.0705 -0.0002 0.0000 0.0070 0.1293 0.0147
41

Panel B: Spreads and signed lagged returns

Estimated Coefficients R
m,t-1
R
m,t-2
R
m,t-3
R
m,t-4
R
i,t-1
R
i,t-2
R
i,t-3
R
i,t-4

Mean -0.3608*** -0.3499*** -0.0135 0.0212 -0.0639*** -0.0617*** -0.0567*** -0.0699***
Median -0.1914 -0.2316 0.0145 0.0441 -0.0691 -0.0407 -0.0452 -0.0526
Estimated Coefficients
R
m,t-1
*
crisis
R
m,t-2
*
crisis
R
m,t-3
*
crisis
R
m,t-4
*
crisis
R
i,t-1
*
D
down,i,t-1

R
i,t-2
*
D
down,i,t-2

R
i,t-3
*
D
down,i,t-3

R
i,t-4
*
D
down,i,t-4

Mean -0.4496*** -0.0722*** -0.0526* 0.1542*** -0.0201 -0.0020 0.0314*** 0.0658***
Median -0.2169 -0.0067 -0.0459 0.0096 0.0094 -0.0024 0.0250 0.0482
Panel C: Spreads and funding constraints
Estimated Coefficients R
m,t-1
R
m,t-2
R
m,t-3
R
m,t-4

R
m,t-1
*
crisis R
m,t-2
* crisis
R
m,t-3
*
crisis
R
m,t-1
*
crisis *
D
CAP,t-1

Mean -0.3604*** -0.3534*** -0.0145 0.0164 -0.4117*** -0.0843** -0.0338 -0.1108
Median -0.1870 -0.2338 0.0170 0.0383 -0.1208 0.0051 -0.0461 -0.0869
***, ** and * represent significance at 1%, 5% and 10% respectively.
42
Table 5
Effect of funding liquidity on market liquidity
Panel A: Stage I
We orthogonalize net acquisition of financial assets by security brokers and dealers (in 100 billion
dollars) at quarterly frequency. We run the following regression and use the residuals of this model as an
independent variable in Panel B:
Net acquisition of financial assets = f(TED spread, T-bill rate) + u
TED is defined as the difference between the LIBOR (London Interbank Offered Rate) and the U.S.
Treasury bill rate.
Variable Net acquisition of financial assets
Intercept 5.62
TED -12.34***
T-bill rate 1.95**
Adjusted R Square 0.6808
Number of Observations 16

Panel B: Stage II
We report coefficient estimates from regressions of trading cost (relative effective spread) on TED
spread which is a proxy for funding liquidity and residuals from Panel A regression. The model is
estimated over 16 quarters in our sample. Other control variables include volatility, log (market
capitalization) and log (dollar trading volume) averaged over each quarter. Volatility for each stock-day is
computed as standard deviation of quote mid-point returns during the day.
Dependent variable Relative Effective Spread
Model 1 Model 2 Model 3
Intercept 0.5858*** 0.5849*** 3.9181***
TED 0.1746*** 0.1759*** 0.1346***
Residuals from Stage I -0.0073*** -0.0036***
Log(Market capitalization) -0.0821***
Log(Dollar trading volume) -0.167***
Volatility 5.6734***
Adjusted R Square 0.0124 0.0144 0.6762
Number of Observations
71,862 71,862 71,862

***, ** and * represent significance at 1%, 5% and 10% respectively.


43
Table 6
Granger causality test of funding liquidity and market liquidity
We take cross sectional average of all the stock level variables during our sample and run the following
time series regressions:
Funding liquidity
t
=

0
+
1
Funding liquidity
t-1
+
2
Market liquidity
t-1
+
t

Market liquidity
t
=

0
+
1
Funding liquidity
t-1
+
2
Market liquidity
t-1
+ Control variables +
t
TED spread is a proxy for funding liquidity and relative effect spread is a measure of market liquidity.
We control for contemporaneous T-bill rate in model 1 and contemporaneous market volatility in model 2.
Variable TED
t
Relative effective spread
t

Intercept -0.0040*** 0.0001
TED
t-1
0.1025*** 0.0432***
Relative effective spread
t-1
-0.0250 -0.4800***
T-bill rate
t
-0.9962***
Market volatility
t
-0.0047
Adjusted R Square 0.8327 0.2387
Number of Observations 980 980
***, ** and * represent significance at 1%, 5% and 10% respectively.


44
Table 7
Dynamic relationship between funding liquidity and market liquidity
We report coefficient estimates from regressions of trading cost (relative effective spread) on funding liquidity (TED) in model 1. The model is
estimated using firm-observations at daily level for a period from 2006 to 2009. In model 2, we include all NYSE, Nasdaq, and AMEX-listed
stocks and use volatility, log (market capitalization), and log (dollar trading volume) as the control variables. Volatility for each stock-day is
computed as standard deviation of quote mid-point returns during the day. In model 3, we only include firms that received tarp funding. Before
Tarp event takes a value of 1 before the tarp issue date, and 0 otherwise. After Tarp event takes a value of 1 after the tarp issue date, and 0
otherwise. In model 4, financial takes a value 1 for all financial firms, and 0 otherwise. Non-financial takes a value 1 for all non-financial firms,
and 0 otherwise. In model 5, we assign a value of 1 to too-big-to-failto11 largest financial firms at the end of each year following Jagtiani and
Brewer (2011), and 0 otherwise. Not too-big-to-fail takes a value of 1 for all firms except 11 largest financial firms during each year, and 0
otherwise. In model 6, crisis takes a value of 1 for the period September 2008-December of 2008, and 0 otherwise. Non-crisis takes a value of 1
for the period excluding September-December of 2008, and 0 otherwise. In model 7, we exclude the crisis period from our sample.
Dependent Variable= Relative Effective Spread
Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7
Explanatory variables: All firms All firms TARP firms fin vs. non-fin too-big-to-fail crisis non-crisis
Intercept 0.4532*** 3.5323*** 2.5809*** 3.5327*** 3.5596*** 3.5728*** 3.5155***
TED 0.0865*** 0.0922*** 0.0155***
TED * after Tarp event 0.4752***
TED * before Tarp event 0.1416***
TED * financial 0.0943***
TED * non-financial 0.0918***
TED * too-big-to-fail 0.6207***
TED * not too-big-to-fail 0.0904***
TED * crisis 0.1215***
TED * non-crisis 0.0175***
Log(Market capitalization) -0.1058*** -0.0302*** -0.106*** -0.1085*** -0.104*** -0.1071***
Log(Dollar trading volume) -0.1173*** -0.134*** -0.1172*** -0.1168*** -0.1186*** -0.1116***
Volatility 1.4984*** 6.932*** 1.4982*** 1.4854*** 1.4678*** 1.3088***
Adjusted R Square 0.0054 0.4475 0.4325 0.4475 0.4491 0.4514 0.4442
Number of Observations 3,827,058 3,827,058 161,989 3,827,058 3,827,058 3,827,058 3,464,782
***, ** and * represent significance at 1%, 5% and 10% respectively.