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Market-Based Solutions to Vital Economic Issues


Kenan Institute 2024 Grand Challenge: Business Resilience
Market-Based Solutions to Vital Economic Issues
Mar 2, 2017

Liquidity Risk and Bank Stock Returns


We document that higher measures of liquidity risk on banks balance sheets are associated with lower expected stock returns. We first calculate a measure of liquidity risk, referred to as the liquidity gap (LG), which reflects how much of a bank’s volatile liabilities are covered by its stock of liquid assets. We show that the standard factor models — even when augmented with bond risk, market liquidity, and financial-size factors — do not fully explain the cross section of bank stock returns sorted according to this measure. A portfolio that is long in low liquidity risk banks and short in high liquidity risk banks delivers a statistically significant alpha of 6 percent annually. This effect is not driven by bank characteristics such as size, profitability, or risk measures related to leverage or asset quality, but appears to be partly due to the degree of complexity of banking organizations and potential valuation errors pre-crisis.

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