Safety, Liquidity, and Crises

Introduction

Over the past 15 years, the euro area experienced two large financial crises (global financial; debt crisis), and two non-financial crises (Covid, war/energy) with spillovers to the financial system. Curiously, all these crises involved distress in markets for assets which were supposedly liquid and safe: for example, repos and MBS in 2008, and sovereign bonds in the 2010 euro-area and October 2022 UK crises.

Literature Gap

But even though liquidity and safety play a key role in theories and narrative accounts of crises, most empirical studies of crises focus on risk, creating a key gap in the literature.

Proposal Overview

My proposal will fill this gap by conducting the first systematic study of the role market liquidity and safe assets play in financial crisis events. To do this, I will collect new long-run data on:

1. Quantities of safe and liquid assets (produced by financials and governments).
2. Prices of liquidity and safety (measured by bid-ask and yield spreads), for 17 advanced economies during 1870–2020.

Research Objectives

I will use these data to better understand which assets are safe and liquid, and what role liquidity and safety play in the build-up and aftermath of systemic crisis events. To do this, I propose five projects to study:

1. How quantities of safe assets evolve over the long run, and around crises.
2. How safety & liquidity vary across & within asset classes, and over time.
3. How market liquidity relates to crisis risk and real activity.
4. How liquidity and solvency stress transmit and interact at bank level during crises.
5. How changes in quantities of safe and liquid assets affect their prices.

Methodology

The initial analysis will be empirical, done at macro level. It will be complemented by theory (project 1), and micro-level security/bank-level evidence (projects 2–4) to improve identification and understand the mechanisms at play.