Measuring Liquidity Mismatch in the Banking Sector

Working Paper: NBER ID: w22729

Authors: Arvind Krishnamurthy; Jennie Bai; Charles-Henri Weymuller

Abstract: This paper implements a liquidity measure, “Liquidity Mismatch Index (LMI),” to gauge the mismatch between the market liquidity of assets and the funding liquidity of liabilities. We construct the LMIs for 2882 bank holding companies during 2002-2014 and investigate the time-series and cross-sectional patterns of banks' liquidity and liquidity risk. Aggregate banking sector liquidity worsens from +$4 trillion before the crisis to -$6 trillion in 2008, and reverses back to the pre-crisis level in 2009. We also show how a macro-prudential liquidity stress test can be conducted with the LMI metric, and that such a stress test could have revealed the fragility of the banking system in early 2007. In the cross section, we find that banks with more ex-ante liquidity mismatch have a higher stock-market crash probability and are more likely to borrow from the government during the financial crisis. Thus the LMI measure is informative regarding both individual bank liquidity risk as well as the liquidity risk of the entire banking system. We compare the LMI measure of liquidity to other measures such as Basel III's liquidity coverage ratio and net stable funding ratio, and show that LMI performs better in many dimensions. The outperformance of LMI partially results from the contract-specific time-varying liquidity sensitivity weights which are driven by market prices.

Keywords: Liquidity; Banking Sector; Liquidity Mismatch Index; Financial Stability

JEL Codes: E44; E51; G21; G28

Causal Claims

Cause	Effect
liquidity mismatch index (LMI) (G33)	probability of stock market crashes (G17)
liquidity mismatch index (LMI) (G33)	likelihood of government borrowing during financial crises (H74)
liquidity mismatch index (LMI) (G33)	liquidity stress events (G33)
liquidity mismatch index (LMI) (G33)	predicting liquidity outcomes (G33)