All Times ET
Keywords: Change point detection, COVID-19, Dynamic spike and slab prior, Financial distress
During episodes of financial distress, such as the COVID-19 pandemic, banks serve as the primary source of liquidity to firms. Consequently, banks that have large buffers of liquidity available for emergency assistance to firms, usually receive a notably higher equity valuation during crises, which then recedes during normal times. In this article, we develop a hierarchical Bayesian procedure to study the dynamics of bank stock returns to changes in their capacity to provide liquidity and identify structural changes in this relationship over the last 30 years. Our hierarchical model relies on a dynamic extension of the spike-and-slab prior (George and McCulloch, 1993; Rockova et al., 2020) that identifies change points in the relationship between bank stock prices and their liquidity buffers. Moreover, the proposed framework provides data-driven predictions of future change points using financial covariates. Our analysis uncovers previously overlooked instances of structural changes in the relationship between bank liquidity and equity returns. Overall, bank stocks generated larger returns to liquidity over a broad range of systemic shocks.