RESEARCH ARTICLE Contemporaneous linkages: Funding liquidity and stock market spirals Ajay Kumar Mishra 1 | Bhavik Parikh 2 | Ronald W. Spahr 3 1 Vinod Gupta School of Management, Indian Institute of Technology (IIT) Kharagpur, Kharagpur, West Bengal, India 2 Schwartz School of Business, St. Francis Xavier University, Antigonish, Canada 3 Department of Finance, Insurance and Real Estate, Fogelman College of Business & Economics, The University of Memphis, Memphis, Tennessee Correspondence Ajay Kumar Mishra, Vinod Gupta School of Management, Indian Institute of Technology (IIT) Kharagpur, Kharagpur 721 302, West Bengal, India. Email: akmishra@vgsom.iitkgp.ac.in Abstract We observe, especially during financial crisis periods, that central bank poli- cies may trigger credit rationing and borrowing cost increases, resulting in con- temporaneous institutional lender and market maker funding illiquidity. In turn, funding illiquidity is transmitted through banks and broker/dealers to market illiquidity of individual stocks. Thus, funding illiquidity, often originat- ing with central bank monetary policy, is contemporaneously conveyed through institutional lenders, transferred to broker/dealers and spawns inter- connected stock market illiquidity spirals and loss spirals. Our results are con- sistent and robust across different models that control for endogenous and exogenous factors. KEYWORDS federal reserve, financial crisis, funding liquidity, stock market liquidity 1 | INTRODUCTION Market liquidity is imperative for efficient and effective capital markets, where illiquidity may adversely affect stock market pricing. During liquidity “dry-up” periods, particularly around periods of the economic or financial crisis, institutional lenders, generally commercial banks, experience systemic funding illiquidity, resulting in credit rationing and higher lending costs. Thus, bank illiquidity is transferred to market-makers, resulting in systemic credit rationing, higher borrowing costs, further deterio- ration of stock liquidity and declining stock prices. We contribute to the literature in several ways. First, we define measure stock liquidity using illiquidity and loss spirals that often are observed during market crisis periods, when liquidity is deteriorating and funding is restricted. We find that illiquidity spirals and loss spirals are mutually reinforcing. Illiquidity spirals tend to trigger loss spirals and vice-versa. Second, we identify dynamic and inter-dependent linkages among institutional lender funding liquidity and individual stock liquidity that is stronger during financial crisis and illiquidity spiral periods. Third, we observe that broker/dealers more actively adjust stock inventories during illiquidity periods. Thus, we observe market-makers/broker-dealer pullback occurring during financial crisis events that exacerbate stock illiquidity problems. We find that stock market illiquidity emanates pre- dominately within the banking industry (institutional lender), funding illiquidity; where, bank funding illiquid- ity appears to be the root cause of credit rationing that is contemporaneously transmitted to, individuals, market- makers (broker/dealers) and individual stocks and nega- tively affect liquidity and prices. However, at times, usu- ally at the beginning of a financial crisis, lender funding liquidity is driven by insufficient central bank/banking system reserves that impact bank balance sheet liquidity, primarily through the liability side. Central bank excess reserves, access to global money markets, and interbank borrowing/lending are primary sources of bank funding liquidity for liability manage- ment banks. Our hypothesis of systemic causes of con- temporaneous stock market liquidity is supported by Acharya and Mora (2015), who find that central bank Received: 12 May 2018 Revised: 4 April 2020 Accepted: 18 June 2020 DOI: 10.1002/ijfe.2100 Int J Fin Econ. 2020;1–18. wileyonlinelibrary.com/journal/ijfe © 2020 John Wiley & Sons, Ltd. 1