Banks' Advantage in Hedging Liquidity Risk: Theory and Evidence from the Commercial Paper Market

Abstract

Banks have a unique ability to hedge against market-wide liquidity shocks. Deposit inflows provide funding for loan demand shocks that follow declines in market liquidity. Consequently, banks can insure firms against systematic declines in liquidity at lower cost than other institutions. We provide evidence that when liquidity dries up and commercial paper spreads widen, banks experience funding inflows. These flows allow banks to meet loan demand from borrowers drawing funds from commercial paper backup lines without running down their holdings of liquid assets. We also provide evidence that implicit government support for banks during crises explains these funding flows. Copyright 2006 by The American Finance Association.

Has Finance Made the World Riskier?

“…One of the advantages of banks is that they can be well diversified across liquidity needs in the system and can thus provide liquidity most efficiently to those who need it (Kashyap et al , 2002). Gatev and Strahan (2004) show that when the commercial paper market dried up for many issuers following the Russian crisis in 1998, banks with higher levels of transaction deposits were perceived (by the stock market) to be lower risk. They experienced larger inflows of funds – possibly from investors fleeing the commercial paper market – just when firms denied access to commercial paper started taking down back‐up lines of credit from these banks.…”

Can Bank Lines of Credit Protect REITs against a Credit Crisis?

“…The interest concession would also mitigate any potential underinvestment problem. Other supply‐based reasonings in favor of loan commitments include the commercial banks gaining credibility by honoring promises made under the credit lines (Boot, Thakor and Udell 1991), managing uncertain loan demands more efficiently (Greenbaum, Kanatas and Venezia 1991) and enjoying cost advantages over other financial institutions (Gatev and Strahan 2006).…”

“…Hypothesis 1 predicts that REITs will draw down their bank lines of credit in a tight credit market. We follow Gatev and Strahan (2006) in using the paper‐bill spread, which is defined as the difference between the interest rate on the‐month commercial paper of high‐grade (Aa) nonfinancial borrowers and the 3‐month Treasury bill, as a proxy for market liquidity. Figure 1 charts the paper‐bill spread between 1992:Q1 to 2007:Q4.…”

Commodity Prices and Bank Lending

“…Insofar as banks cannot easily substitute deposit funding with wholesale funding (which is typically the case in developing countries), they would respond by curtailing credit (Jayaratne and Morgan ; Kashyap and Stein ; Khwaja and Mian ). The funding shock may end up affecting the credit supply of banks with lower deposits‐to‐assets ratios (Gatev and Strahan ), a channel that could be stronger in developing countries, where banks heavily rely on retail funding. Moreover, government arrears and weak revenue growth of commodity dependent firms may render them unable to service their loans, thereby worsening bank asset quality and eroding capital of banks highly exposed to the commodity sector (Christensen ; Kinda, Mlachila, and Ouedraogo ).…”