Does lending relationship help or alleviate the transmission of liquidity shocks? Evidence from a liquidity crunch in China

We examine China’s June 2013 liquidity crunch as a negative shock to banks and analyze the wealth effects on exchange-listed firms. Our findings suggest that liquidity shocks to financial institutions negatively impact borrower performance, particularly borrowers reporting outstanding loans at the end of 2012. Stock valuations of firms with long-term bank relationships, however, outperform the market and experience smaller subsequent declines in investment than peers lacking solid banking relationships. This effect is the strongest for firms that enjoy good relations with China’s large state-owned banks or foreign banks, and weakest for firms whose connections are solely with local banks. We document a positive correlation between the stock performances of firms and the stock performances of lender banks and the likelihood of lender banks operating as net lenders in the interbank market. These results suggest that banks transmit liquidity shocks to their borrowing firms and that a long-term bank-firm relationship may mitigate the negative effects of a liquidity shock.     

The use of bank lines of credit in corporate liquidity management: A review of empirical evidence

This paper reviews empirical evidence on the use of bank lines of credit as a source of corporate liquidity. Traditional explanation for lines of credit is that they provide insurance against liquidity shocks, in much the same as way hoarding cash does. However, recent empirical research suggests that access to lines of credit is contingent on the credit quality of the borrower as well as the financial condition of the lender. These findings suggest that lines of credit are an imperfect substitute for cash as a source of corporate liquidity.     

A lender-based theory of collateral

We consider an imperfectly competitive loan market in which a local relationship lender has an information advantage vis-à-vis distant transaction lenders. Competitive pressure from the transaction lenders prevents the local lender from extracting the full surplus from projects. As a result, the local lender inefficiently rejects marginally profitable projects. Collateral mitigates the inefficiency by increasing the local lender's payoff from precisely those marginally profitable projects that she inefficiently rejects. The model predicts that, controlling for observable borrower risk, collateralized loans are more likely to default ex post, which is consistent with the empirical evidence. The model also predicts that borrowers for whom local lenders have a relatively smaller information advantage face higher collateral requirements, and that technological innovations that narrow the information advantage of local lenders, such as small business credit scoring, lead to a greater use of collateral in lending relationships.     

Rare event risk and emerging market debt with heterogeneous beliefs

In a setting where the lender and the borrower have heterogeneous beliefs about the likelihood of a disastrous shock to the borrower's economy, we study the debt contract that defaults at the occurrence of that shock, as proposed by Barro (2006). We find that a higher belief by the lender compared to the borrower can lead to countercyclical interest rates and credit spreads in non-default times, and to an increase in the borrower's indebtedness in default times, as often observed in emerging market economies. When calibrating the model to prices in the credit default swap market, we show that heterogeneous beliefs can account for more than 40% of the variation in CDS spreads associated with shocks to the borrower's economy in non-default times.     

Understanding commonality in liquidity around the world

We examine how commonality in liquidity varies across countries and over time in ways related to supply determinants (funding liquidity of financial intermediaries) and demand determinants (correlated trading behavior of international and institutional investors, incentives to trade individual securities, and investor sentiment) of liquidity. Commonality in liquidity is greater in countries with and during times of high market volatility (especially, large market declines), greater presence of international investors, and more correlated trading activity. Our evidence is more reliably consistent with demand-side explanations and challenges the ability of the funding liquidity hypothesis to help us understand important aspects of financial market liquidity around the world, even during the recent financial crisis.     

Common liquidity shocks and market collapse: Lessons from the market for perps

We show how a high degree of commonality in investor liquidity shocks can diminish incentives for intermediaries to keep markets open and lead to market collapse, even without information asymmetry or news affecting fundamentals. We motivate our model using the perpetual floating-rate note market where two years of explosive growth – in which issues by high quality borrowers were placed with institutional investors and traded in a liquid secondary market – were followed by a precipitous collapse when market intermediaries withdrew due to large order imbalances. We shed new light on the trade-off between ownership concentration and market liquidity.     

Consequences of Debt Forgiveness: Strategic Default Contagion and Lender Learning

I use a unique data set of loans to small business owners to examine whether lenders face adverse consequences when they grant debt forgiveness to borrowers. I provide evidence consistent with borrowers communicating their debt forgiveness to other borrowers, who then more frequently strategically default on their own obligations. This strategic default contagion is economically large. When the lender doubles debt forgiveness, the default rate increases by 10.9% on average. Using an exogenous shock to the lender's forgiveness policy, my findings suggest that as the lender learns about the extent of borrower communication the lender tightens its debt forgiveness policy to mitigate default contagion.     

The Systemic Risk of Cross-Border Banking: Evidence from the Sudden Stop and Interbank Stress Contagion in East Asia

This article investigates the systemic risk of cross-border banking in East Asia. Using the recursive bivariate probit model, we jointly test the probability of the sudden stop in international lending and its simultaneous effect on the host countries’ interbank markets. The empirical results suggest that the risk of a sudden stop is associated with global liquidity shock; host country productivity shock; and the common lender contagion effect. This facilitates the transmission of interbank stress from advanced economies to emerging markets. However, the tension is mitigated by the “flight-home effect” caused by domestic investors’ repatriation. The sudden stop is more likely to occur in countries with lower financial openness but higher financial risk. Lending flows to the banking sectors are more sensitive to shocks than the flows to the non-bank private sectors.     

Tests of ex ante versus ex post theories of collateral using private and public information

Collateral is a widely used, but not well understood, debt contracting feature. Two broad strands of theoretical literature explain collateral as arising from the existence of either ex ante private information or ex post incentive problems between borrowers and lenders. However, the extant empirical literature has been unable to isolate each of these effects. This paper attempts to do so using a credit registry that is unique in that it allows the researcher to have access to some private information about borrower risk that is unobserved by the lender. The data also include public information about borrower risk, loan contract terms, and ex post performance for both secured and unsecured loans. The results suggest that the ex post theories of collateral are empirically dominant, although the ex ante theories are also valid for customers with short borrower–lender relations that are relatively unknown to the lender.     

Theory and Evidence on the Resolution of Financial Distress

We analyze a financially distressed owner-managed project. Themain results of the model are: (1) borrower default is an endogenousresponse to the anticipated restructuring–foreclosureoutcome; (2) the lender’s restructuring–foreclosuredecision depends critically on the interaction between projectvalue and industry liquidity; and (3) the lender waits for theindustry to recapitalize before selling assets obtained throughforeclosure. Empirical analysis of a large sample of defaultedcommercial real estate loans supports many of the model predictions,including restructuring–foreclosure outcomes that areconsistent with endogenous borrower default and firesale discountsthat vary depending on industry market conditions at the timeof foreclosure. (JEL G33)     

Bank Mergers, Competition, and Liquidity

We model the impact of bank mergers on loan competition, reserve holdings, and aggregate liquidity. A merger changes the distribution of liquidity shocks and creates an internal money market, leading to financial cost efficiencies and more precise estimates of liquidity needs. The merged banks may increase their reserve holdings through an internalization effect or decrease them because of a diversification effect. The merger also affects loan market competition, which in turn modifies the distribution of bank sizes and aggregate liquidity needs. Mergers among large banks tend to increase aggregate liquidity needs and thus the public provision of liquidity through monetary operations of the central bank.     

Commitment, banks and markets

We examine how banks and financial markets interact with one another to provide liquidity to investors. The critical assumption is that financial markets are characterized by limited enforcement of contracts, and in the event of default only a fraction of borrowers’ assets can be seized. Limited enforcement reduces the fraction of assets that can be used as collateral and thus individuals subject to liquidity shocks face borrowing constraints. We show how banks endogenously overcome these borrowing constraints by pooling resources across several depositors, and increase the liquidity provided by financial markets.     

Using Interest Rate Derivative Prices to Estimate LIBOR-OIS Spread Dynamics and Systemic Funding Liquidity Shock Probabilities

Following the bankruptcy of Lehman Brothers in mid-September 2008, there were severe disruptions in international money markets and banks reportedly faced severe liquidity shocks in particular US dollar funding shortages, prompting central banks around the world to adopt unprecedented policy measures to supply funds to the banks. A better understanding of the forward-looking information content about funding liquidity risk in interest rate derivative prices is therefore necessary to gauge pressures building surrounding systemic liquidity. Using the market prices of the US dollar LIBOR-overnight index swap spread, we estimate the probability of the systemic funding liquidity shock during the crisis period, which deviated from zero on 17 September 2008 to a significant level. This provided an early warning signal of the systemic liquidity shock on 29 September 2008 when the interbank market was totally paralysed.     

Bank-to-bank lending channel and the transmission of bank liquidity shocks: Evidence from France

Good liquidity is essential for the banking system to function properly and supply credit to the real sector. However, several banks all over the world face large shocks to their liquidity supply due to numerous factors. This study contributes to the literature on the transmission of liquidity shocks by investigating the bank-to-bank lending behavior of French banks during the global financial crisis (2008 and 2009). In addition, we examine the factors strongly influencing the liquidity of the interbank deposits market. First, using a fixed-effects model on a sample of 85 French banks for the period from 2005 to 2010, we find that the deposits channel plays an important role in the transmission of liquidity shocks across the banking system. Second, we use difference-in-difference methodology to study the effects of liquidity shock on bank lending. Our results show that French banks reduced their bank-to-bank lending significantly during the financial crisis period. Moreover, our results suggest that the reduction could have been due to deposit activities.     

The Role of Soft Information in a Dynamic Contract Setting: Evidence from the Home Equity Credit Market

Credit underwriting is a dynamic process involving multiple interactions between borrower and lender. During this process, lenders have the opportunity to obtain hard and soft information from the borrower. We analyze more than 108,000 home equity loans and lines‐of‐credit applications to study the role of soft and hard information during underwriting. Our data set allows us to distinguish lender actions that are based strictly on hard information from decisions that involve the collection of soft information. Our analysis confirms the importance of soft information and suggests that its use can be effective in reducing overall portfolio credit losses ex post.     

The liquidity risk of liquid hedge funds

This paper evaluates hedge funds that grant favorable redemption terms to investors. Within this group of purportedly liquid funds, high net inflow funds subsequently outperform low net inflow funds by 4.79% per year after adjusting for risk. The return impact of fund flows is stronger when funds embrace liquidity risk, when market liquidity is low, and when funding liquidity, as measured by the Treasury-Eurodollar spread, aggregate hedge fund flows, and prime broker stock returns, is tight. In keeping with an agency explanation, funds with strong incentives to raise capital, low manager option deltas, and no manager capital co-invested are more likely to take on excessive liquidity risk. These results resonate with the theory of funding liquidity by Brunnermeier and Pedersen (2009).     

Bank size and macroeconomic shock transmission: Does the credit channel operate through large or small banks?

In this paper, I use U.S. call report data to construct a larger panel dataset with bank-level observations. I find that larger banks' lending is considerably more sensitive to the strength of their borrowers' and their own balance sheets compared to smaller banks and that the sensitivities to borrower balance sheets are larger in magnitude compared to lender balance sheets. When I incorporate various macroeconomic shocks (identified by an estimated DSGE model) into the empirical model, I similarly find that the transmission of shocks to the real economy operates mostly through large bank lending and borrower balance sheets.     

TARP announcement,bank health,and borrowers’ credit risk

Theory suggests that unhealthy banks exhibit more pronounced flight-to-quality behavior during financial crises and, hence, the infusion of capital through unhealthy banks is less effective in relieving the liquidity shocks of vulnerable borrowers. We test these predictions by investigating how the financial health of leading US banks influenced their borrowers’ credit risk surrounding the announcement of the Troubled Asset Relief Program (TARP). Changes in borrower credit risk, measured by credit default swap (CDS) spreads, should reflect the expected relief from liquidity shocks and other benefits of rescuing banks, such as maintaining the existing lending relationships. Consistent with the theory, prior to the TARP capital infusions, unhealthy banks’ borrowers with high leverage experienced a greater increase in their credit risk relative to similar healthy banks’ borrowers. Following the event, the CDS market anticipated less liquidity relief to these vulnerable unhealthy banks’ borrowers, but more liquidity relief to the vulnerable healthy banks’ borrowers.     

Hedge funds as liquidity providers: Evidence from the Lehman bankruptcy

Hedge funds using Lehman as prime broker faced a decline in funding liquidity after the September 15, 2008 bankruptcy. We find that stocks held by these Lehman-connected funds experienced greater declines in market liquidity following the bankruptcy than other stocks; the effect was larger for ex ante illiquid stocks and persisted into the beginning of 2009. We find no similar effects surrounding the Bear Stearns failure, suggesting that disruptions surrounding bankruptcy explain the liquidity effects. We conclude that shocks to traders' funding liquidity reduce the market liquidity of the assets that they trade.     

So what do I get? The bank's view of lending relationships

While many empirical studies document borrower benefits of lending relationships, less is known about lender benefits. A relationship lender's informational advantage over a non-relationship lender may generate a higher probability of selling information-sensitive products to its borrowers. Our results show that the probability of a relationship lender providing a future loan is 42%, while for a non-relationship lender, this probability is 3%. Consistent with theory, we find that borrowers with greater information asymmetries are significantly likely to obtain future loans from their relationship lenders. Relationship lenders are likely to be chosen to provide debt/equity underwriting services, but this effect is economically small.