This paper explores the interaction between funding liquidity and market liquidity. The simultaneous reduction of funding and market liquidities is often observed during financial crises. While Brunnermeier and Pedersen (2009) argue that fragility of liquidity is due to a destabilizing effect of margin calls triggered by uninformed traders' behavior under uncertainty, Nyborg and Östberg (2014) claim that the malfunction in interbank funding markets causes declines in market liquidity in broader financial markets. We demonstrate that Nyborg and Östberg's cause was dominant during the subprime financial crisis, while both causes were valid during the European sovereign debt crisis using a structural vector autoregression model.
Keywords: Funding Liquidity; Market Liquidity; Limits of Arbitrage
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.