A New Perspective on Bank-Dependency: The Bank Liquidity Channel
Event details
| Date | 11.12.2015 |
| Speaker | Filippo IPPOLITO (Universitat Pompeu Fabra) |
| Location | |
| Category | Conferences - Seminars |
We propose a novel channel through which shocks to bank health affect real economic activity. This channel arises from the provision of liquidity insurance from banks to firms, through pre-committed credit lines. While bank-dependency is usually associated with low credit quality, liquidity insurance through credit lines is most common for large, high credit quality firms. We propose a model that matches this cross-section of bank dependency and liquidity insurance, and test its empirical implications. Shocks to bank health affect firms that rely on credit lines in two different ways. First, weak banks are less likely to waive covenant violations, and more likely to withhold funds under pre-committed lines of credit. Second, firms that rely on credit lines, but which have not violated covenants, tend to switch from credit lines to cash. This substitution from credit lines into cash by high quality firms can amplify the negative shock to bank health, by draining bank liquidity. This amplification effect can contaminate the provision of regular loans to bank-dependent firms, and thereby cause large negative effects on real activity. We test the main implications of the model by examining the freeze-out of the Asset-Backed Commercial Paper (ABCP) market in late 2007. We find that banks with larger exposure to the ABCP market offer tighter conditions on credit lines for borrowers that are in breach of a covenant, when compared with banks with a lower exposure to ABCP. At the same time, banks with large ABCP exposure offer easier conditions on terms loans. These effects are not driven by selection of borrowers, nor by different contract conditions. Our findings suggest that tighter conditions on credit lines are motivated by liquidity management at banks, and that banks allocate scarce liquidity to loans rather than credit lines, in times of financial market stress. Banks' optimal allocation of liquidity also appear to affect firms' responses to covenant violations: greater leniency from banks is associated with higher borrowing, employment, and sales growth.
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