Interbank and stock market liquidity : an empirical analysis of the market connection in Norway

This thesis is a study of the connection between demand for liquidity in the interbank market and liquidity in the stock market in Norway for the period from 2003 to 2017. The thesis examines whether increased price of liquidity in the interbank market leads banks to explore alternative sources of obtaining liquidity, such as selling financial assets they keep on the balance sheet. This process is termed “liquidity pull-back”. To test the liquidity pull-back hypothesis, stocks on the Oslo Stock Exchange are sorted into ten portfolios based on their liquidity. The market share of daily trading volume of each liquidity portfolio is then regressed on the price of liquidity in the interbank market, measured by IBOR-OIS and TED spreads for the currencies USD, NOK and Euro. The expectation of the hypothesis is that the market share of volume of the most liquid portfolio increases relative to less liquid portfolios when the price of liquidity in the interbank market increases. The alternative hypothesis is portfolio rebalancing as a result of increased uncertainty. This is controlled for with the inclusion of the VIX. The empirical analysis is supplemented with qualitative analysis which includes interviews with market participants. The findings of the analysis lend support to the liquidity pull-back hypothesis for the pre-financial crisis period of 2003 to 2007. However, there is no evidence in favour of the hypothesis in the years after the crisis. Reasons for this appear to be low activity in the Norwegian interbank market and regulations making it expensive for banks to keep stocks on the balance sheet. There is stronger evidence to support the portfolio rebalancing hypothesis, as investors reduce equity exposures in times of increasing uncertainty in financial markets