Transmission of liquidity shock to bank credit: Evidence from the deposit insurance reform in Japan

Finding the causal effects of liquidity shocks on credit supply is complicated by the endogenous relation between loan demand and liquidity position of banks. This paper attempts to overcome this problem by exploiting, as a natural experiment, the exogenous deposit outflow prompted by the removal of a blanket deposit guarantee on time deposits in Japan. We find that during the period of transition from a blanket guarantee to a partial guarantee, weak banks suffered from a large outflow of partially insured time deposits. More importantly, we find that those weak banks were not able to raise a sufficient amount of other types of deposits to make up for the loss of time deposits, which, consequently, forced them to cut back on loan supply. These results are consistent with the theory that the imperfect substitutability of insured deposits and uninsured deposits affects the tightness of banks’ financing constraints and ultimately the supply of bank loans.