Sovereign Credit Risk, Liquidity, and ECB Intervention: Deus Ex Machina?

Journal of Financial Economics, Vol. 122, Issue 1, pp. 86-115
Loriana Pelizzon,
Marti Subrahmanyam,
Davide Tomio,
Jun Uno
Reseach Area:
Systemic Risk Lab, Financial Markets

We examine the dynamic relation between credit risk and liquidity in the Italian sovereign bond market during the eurozone crisis and the subsequent European Central Bank (ECB) interventions. Credit risk drives the liquidity of the market. A 10% change in the credit default swap (CDS) spread leads to a 13% change in the bid-ask spread, the relation being stronger when the CDS spread exceeds 500 basis points. The Long-Term Refinancing Operations of the ECB weakened the sensitivity of market makers’ liquidity provision to credit risk, highlighting the importance of funding liquidity measures as determinants of market liquidity.

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