Funding Constraints and Market Illiquidity in the European Treasury Bond Market

Theoretical studies show that shocks to funding constraints should affect and be af-fected by market illiquidity. However, little is known about the empirical magnitude of such responses because of the intrinsic endogeneity of illiquidity shocks. This paper adopts an identification technique based on the heteroskedasticity of illiquidity proxies to infer the reaction of one measure to shocks affecting the other in a joint setting. Using data for the European Treasury bond market, we find evidence of a two-way response occurring between funding and market illiquidity shocks. In the cross-section, we show that individual bonds’ illiquidity responses to funding or market illiquidity shocks vary with with bond maturity, the credit risk of the issuer, haircuts, and the number of bonds issued by the country.