Understand Funding Liquidity and Market Liquidity in a Regime-switching Model

We investigate the time-varying relationship of funding liquidity (FL) and market liquidity (ML) in a Markov regime-switching model. By using a comprehensive U.S. TRACE dataset, we provide strong evidence that FL and corporate bond ML are interlinked, and their impact on each other is highly regime-dependent. We find that FL and ML exhibit a large-and-positive mutual impact when money market is tight and equity market is volatile. But in normal regimes, FL is found to have a negative impact on ML with a much smaller magnitude than those in stressed regimes. Furthermore, FL is more stable than ML with less regime changes. Our paper offers insight on the important mechanism by which central banks can improve ML through the funding market.