As conventional wisdom has it, markets stall during financial crises, as sellers struggle to find their buyers. For example, describing the current subprime lending crisis, Paul Krugman notes “…[M]arkets in stuff that is normally traded all the time … have shut down because there are no buyers” (The New York Times, Aug. 11, 2007). Many other similar quotes can be found in major newspapers describing the LTCM, Russian, and Mexican crises, among others.
But an empirical assessment of what really goes on with secondary market liquidity in periods of financial distress is far from trivial. In a recent paper with Eduardo Levy Yeyati and Neeltje Van Horen, “Emerging Market Liquidity and Crises,” we conduct the first systematic empirical study of secondary market liquidity under stress across emerging market crises.
We find no evidence of market “paralysis” at the beginning of crises; secondary market activity does not appear to break down. If anything, trading activity increases as prices fall abruptly, to decline only later as crises progress. However, the cost of making transactions increases sharply; prices react more strongly to each dollar transacted and bid-ask spreads widen. (See figures below.) Thus, whereas trading activity moves inversely to trading costs during tranquil times (and across securities), both increase during crises.
These results are consistent with the view that crises are associated with portfolio reallocation among heterogeneous agents that do not fully anticipate crises (hence, volume increases during market downturns, rather than before) and with fire sales by liquidity constrained investors paying a hefty premium to bring in outside capital. The results also suggest that distressed reallocations between liquid and illiquid investors are feasible but costly.