Stock market liquidity, funding liquidity, financial crises and quantitative easing

Using data from 2003 to 2013, we examine liquidity linkages, originating with the U.S. Federal Reserve Bank (FED) reserve creation, resulting from conventional and non-conventional monetary policy. These reserves, in turn, impact commercial bank credits/lending and U.S. stock market liquidity. We find that stock market liquidity varies across different monetary policy subperiods, where liquidity is strongly influenced by changes in bank lending and M2 money velocity. FED monetary policy that results in bank reserve increases generally stimulates bank lending and subsequently, is accompanied by stock liquidity gains. These linkages were observed during the 2007–09 recession and QE-1 subperiods, where increasing FED assets and bank credits were accompanied by stock liquidity increases. However, even though FED assets and excess bank reserves increased substantially during QE-2 and QE-3, we find no commensurate increases in bank lending/credits or M2 Velocity. We find that QE-2 and QE-3 had no effect or negative impacts on stock liquidity. These findings support our hypothesis that enhancements in stock market liquidity generally occur only when FED stimulus coincides with commensurate increases in bank lending. Additionally, we find positive effects of short-selling during periods of high market uncertainty, and positive effects from the FED being allowed to pay interest on excess reserves (IOER).