Bank loans for private and public firms in a liquidity crunch

Bank reliance on short-term funding has increased over time. While an effective source of financing in good times, the 2007 financial crisis has exposed the vulnerability of banks and ultimately firms to such a liability structure. We show that banks dependent on wholesale funding contracted their lending the greatest during the crisis. Our results suggest, however, that in the financial crisis vulnerable banks passed the liquidity shock only to public firms and not to private firms. Loans to private firms were affected through a different channel, largely through higher retained shares by lead arrangers. Consistent with standard models of financial intermediation with information asymmetry, vulnerable banks increased their monitoring of informationally opaque firms for which the potential for informational rents is the highest.     

Banking Globalization and Monetary Transmission

Globalization of banking raises questions about banks’ liquidity management, their response to liquidity shocks, and the potential for international shock propagation. We conjecture that global banks manage liquidity on a global scale, actively using cross‐border internal funding in response to local shocks. Having global operations insulates banks from changes in monetary policy, while banks without global operations are more affected by monetary policy than previously found. We provide direct evidence that internal capital markets are active in global banks and contribute to the international propagation of shocks. This feature was at play during the financial crisis of 2007–2009.     

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.     

Sovereign collateral as a Trojan Horse: Why do we need an LCR+

Sovereign bonds are widely used as collateral in banks’ funding and trading operations. If a sovereign becomes distressed, the collateral mechanism impairs and banks are suddenly facing significant liquidity calls. Basel III's Liquidity Coverage Ratio (LCR) protects banks against unexpected liquidity calls, but currently excludes sovereign distress. Thus, all banks fulfilling the LCR are still exposed to a liquidity risk stemming from distressed sovereign debt and materializing through the collateral channel. Our paper shows that this unaddressed risk can translate into a system-wide liquidity shock. To gauge the potential damage caused by such a shock, we develop a model based on banks’ home sovereign exposures and a bundle of simplifying assumptions in which sovereign distress triggers bank distress. Our model describes how deteriorating sovereign collateral can lead to an overall liquidity squeeze and non-compliance with Basel III liquidity standards. As this risk is too material to be neglected, we propose an alternative version of the LCR, LCR+, which includes the liquidity impact of sovereign distress.     

Measuring systemic risk-adjusted liquidity (SRL)—A model approach

Little progress has been made so far in addressing—in a comprehensive way—the negative externalities caused by excessive maturity transformation and the implications for effective liquidity regulation of banks. The SRL model combines option pricing theory with market information and balance sheet data to generate probabilistic measure of systemic liquidity risk. It enhances price-based liquidity regulation by linking a bank’s maturity mismatch impacting the stability of its funding with those characteristics of other banks, subject to individual changes in risk profiles and common changes in market conditions impacting funding and market liquidity risk. This approach can then be used (i) to quantify an individual institution’s time-varying contribution to expected losses from system-wide liquidity shortfalls and (ii) to price insurance premia that provide incentives for banks to internalize the social cost of their individual funding decisions.     

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.     

Bank liquidity creation,monetary policy,and financial crises

This paper examines the interplay among bank liquidity creation (which incorporates all bank on- and off-balance sheet activities), monetary policy, and financial crises. We find that: (1) high liquidity creation (relative to trend) – particularly off-balance sheet liquidity creation – helps predict crises, controlling for other factors; (2) monetary policy has statistically significant, but economically minor effects on liquidity creation by small banks during normal times, and these effects are even weaker during financial crises; (3) monetary policy has very little effects on medium and large bank liquidity creation during both normal times and crises. These findings suggest that authorities may wish to monitor bank liquidity creation closely in order to predict and perhaps lessen the likelihood of financial crises. They might also consider other tools to control bank liquidity creation, such as capital and liquidity requirements.     

The good and bad news about the new liquidity rules of Basel III in Western European countries

New liquidity rules phased in under Basel III define the new net stable funding ratio (NSFR) to promote sustainable funding structures at financial institutions. In this paper, we analyze characteristics and drivers of NSFR for a sample of 921 Western European banks between 1996 and 2010. We find that a majority of banks have historically not fulfilled NSFR minimum requirements, in particular larger and faster growing institutions as well as banks also active in asset management and investment banking. Many of them have started increasing NSFR with the onset of financial crisis 2008 while this ratio had been sliding in earlier years. Interestingly, potential advantages in funding costs for low NSFR banks do not seem to translate into higher profitability and results of these banks are more volatile.     

Liquidity risk management and credit supply in the financial crisis

Liquidity dried up during the financial crisis of 2007-2009. Banks that relied more heavily on core deposit and equity capital financing, which are stable sources of financing, continued to lend relative to other banks. Banks that held more illiquid assets on their balance sheets, in contrast, increased asset liquidity and reduced lending. Off-balance sheet liquidity risk materialized on the balance sheet and constrained new credit origination as increased takedown demand displaced lending capacity. We conclude that efforts to manage the liquidity crisis by banks led to a decline in credit supply.     

Asymmetric transmission of a bank liquidity shock

We investigate whether banks that receive a positive liquidity shock make up for the reduction in the amount of credit supplied by banks that suffer a negative liquidity shock. For identification, we use the exogenous shock to the Brazilian banking system caused by the international turmoil of 2008 that sparked a run on small and medium banks toward systemically important banks. We find that a reduction in liquidity causes banks to strongly decrease their loan supply, whereas a positive liquidity shock has a small (if any) effect on the loan supply. Our evidence shows that this asymmetric effect of liquidity on the loan supply occurs both at the intensive and the extensive margins. Our findings are consistent with the theories that predict that borrowers face switching costs and that banks tend to hold on to liquidity during periods of systemic uncertainty.     

Cyclicality of SME lending and government involvement in banks

Recent regulatory efforts aim at lowering the cyclicality of bank lending because of its potentially detrimental effects on financial stability and the real economy. We investigate the cyclicality of SME lending of local banks with versus without a public mandate, controlling for location, size, loan maturity, capitalization, funding structure, liquidity, profitability, and credit demand-side factors. The public mandate is set by local governments and stipulates a sustainable provision of financial services to local customers and a deviation from strict profit maximization. We find that banks with a public mandate are 25% less cyclical than other local banks. The result is credit supply-side driven and especially strong for public mandate banks with high liquidity and stable deposit funding. Our findings have implications for the bank structure, financial stability and the finance-growth nexus in a local context.     

Crises,Liquidity Shocks,and Fire Sales at Commercial Banks

If liquidity shortages cause financial crises, a lender of last resort can provide funds to banks facing potential fire sales. However, if funding problems primarily occur at banks with existing solvency problems, then government liquidity programs may not spur bank lending. We find that commercial bank funding does not typically dry up in a crisis, not even during the subprime crisis. Rather, weak banks are more likely to borrow less. Furthermore, banks rely more on deposits and newly issued equity than fire sales. When they do sell assets, they cherry pick assets in order to alleviate pressure from capital regulations.     

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

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.     

Do stress tests affect bank liquidity creation?

We examine the impact of Federal Reserve stress tests from 2009 to 2016 on U.S. bank liquidity creation. Empirical results show that regulatory stress tests have a negative effect on both on-and off-balance sheet bank liquidity creation and asset-side liquidity creation. As banks enter the stress tests, they reduce their liquidity creation to avoid failing the stress tests. These results are consistent with the hypothesis that banks manage their risk exposures to meet higher capital requirements. The negative effect of stress testing on liquidity creation continues to persist in the quarters after the stress tests. Finally, stress test banks appear to increase liability-side liquidity creation. These findings highlight that the enhanced financial stability from greater regulatory scrutiny may be achieved at the expense of financial intermediation.     

The dark side of liquidity regulation: Bank opacity and funding liquidity risk

We evaluate how the liquidity coverage rule affects US banks’ opacity and funding liquidity risk. Banks subject to the rule become significantly more opaque and funding liquidity risk increases by $245 million per quarter. Higher funding liquidity risk is more pronounced among banks that are subject to the rule’s more stringent liquidity buffers, and systemically riskier banks. Rising opacity reflects an increase in banks’ holdings of complex assets whose value is difficult to communicate to investors. The evidence highlights the unintended consequences of liquidity regulation and is consistent with theoretical models’ predictions of a trade-off between liquidity buffers and bank opacity that exacerbates funding liquidity risk.     

Liquidity regulation and bank lending

Bank liquidity shortages during the global financial crisis of 2007–2009 led to the introduction of liquidity regulations, the impact of which has attracted the attention of academics and policymakers. In this paper, we investigate the impact of liquidity regulation on bank lending. As a setting, we use the Netherlands, where a Liquidity Balance Rule (LBR) was introduced in 2003. The LBR was imposed on Dutch banks only and did not apply to other banks operating elsewhere within the Eurozone. Using this differential regulatory treatment to overcome identification concerns and a difference-in-differences approach, we find that the LBR increased the volume of lending by Dutch banks relative to other banks located in the Eurozone. Increased equity, an inflow of retail deposits and subsequent increase in balance sheet size allowed Dutch banks to increase lending despite having to meet the LBR requirements. The LBR also affected the loan composition of Dutch banks (with corporate and retail lending increasing more than mortgage lending) and the maturity profile of loan portfolios. Our results have relevance for policymakers tasked with monitoring the impact of liquidity regulations on banks and the real economy.     

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.     

Banks’ external financing costs and the bank lending channel: Results from a SVAR analysis

We analyze the dynamic response of banks’ financing costs to structural, macroeconomic shocks, which we identify by imposing combinations of zero and sign restrictions on impulse responses. For the estimation we combine US bank balance sheet data from the Call reports with macroeconomic aggregates over the period from 1984Q1 to 2007Q3. We find that banks’ financing costs mainly respond to monetary policy and aggregate demand shocks. Furthermore, funding costs of undercapitalized and illiquid banks increase more strongly after a contractionary monetary policy shock as compared to better capitalized and more liquid banks. These results provide support for the view that banks’ financing costs represent an important element of the bank lending channel.     

Bank funding structures and risk: Evidence from the global financial crisis

This paper analyzes the evolution of bank funding structures in the run up to the global financial crisis and studies the implications for financial stability, exploiting a bank-level dataset that covers about 11,000 banks in the U.S. and Europe during 2001–09. The results show that banks with weaker structural liquidity and higher leverage in the pre-crisis period were more likely to fail afterward. The likelihood of bank failure also increases with pre-crisis bank risk-taking. In the cross-section, the smaller domestically-oriented banks were relatively more vulnerable to liquidity risk, while the large cross-border (Global) banks were more vulnerable to solvency risk due to excessive leverage. In fact, a 3.5 percentage point increase in the pre-crisis capital buffers of Global banks would have caused a 48 percentage point in their probability of failure during the crisis. The results support the proposed Basel III regulations on structural liquidity and leverage, but suggest that emphasis should be placed on the latter, particularly for the systemically-important institutions. Macroeconomic and monetary conditions are also shown to be related with the likelihood of bank failure, providing a case for the introduction of a macro-prudential approach to banking regulation.     

Funding money-creating banks: Cash funding,balance sheet funding and the moral hazard of currency elasticity

Once banks are viewed as money creators rather than financial intermediaries, a distinction between their cash funding and balance sheet funding can be made. This distinction opens up various insights. It allows for a fuller explanation of the cash needs of banks with reference to the pattern of their cash gains and losses. It facilitates an understanding of the central bank as not only a cash lender of last resort (LOLR) for some banks some of the time, but also as a cash lender of continual and only resort (LOCOR) for all banks all of the time. It leads to novel insights into the sources of banks' balance sheet funding. The paper investigates the various implications of the central bank's elastic currency policy in its role as LOCOR, particularly how it thereby incites considerably more moral hazard than conventionally acknowledged. This realisation opens up a better understanding of the banking sector's proneness to excess and the economy's susceptibility to financial cycles. The paper concludes by weighing the merits of the only two policy strategies by which banking excess can be checked.