Banks Advantage in Hedging Liquidity Risk

It has taken me far too long to find this reference! Therefore, I am re-posting under the Interesting External Papers classification the following (very slightly edited) comments from September 14!

Cushioning fear-driven liquidity shocks is the banks’ bread and butter:

This paper argues that 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, one dimension of bank “specialness” is that banks can insure firms against systematic declines in market liquidity at lower cost than other financial institutions. We provide supporting empirical evidence from the commercial paper (CP) market. When market liquidity dries up and CP spreads increase, banks experience funding inflows. These flows allow banks to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines, without running down their holdings of liquid assets. Using bank-level data, we provide evidence that implicit government support for banks during crises explains the funding flows.

From the same paper, incidentally:

Banks’ functioning as liquidity insurance providers originated early in the development of the commercial paper market. In 1970, Penn Central Transportation Company filed for bankruptcy with more than $80 million in commercial paper outstanding. As a result of their default, investors lost confidence in other large commercial paper issuers, making it difficult for some of these firms to refinance their paper as it matured. The Federal Reserve responded to the Penn Central crisis by lending aggressively to banks through the discount window and encouraging them, in turn, to provide liquidity to their large borrowers (Kane, 1974). In response to this difficulty, commercial paper issuers thereafter began purchasing backup lines of credit from banks to insure against future funding disruptions (Saidenberg and Strahan, 1999).

6 Responses to “Banks Advantage in Hedging Liquidity Risk”

  1. […] US ABCP outstanding declined another $9-billion (slightly more than 1% of the total) in the last week of October, in a continued indication that the unwinding process is proceeding in at least a somewhat orderly fashion. To me, the highlight for the four weeks ending October 31 is that domestic non-financial CP outstanding is down by $12.9-billion while domestic financial CP outstanding is up $52.6-billion; for the month, ABCP outstanding is down $31.5-billion. These numbers suggest – and only suggest, since I haven’t dug very deeply into these numbers! – that re-intermediation is happening big-time in the States, with non-Bank issuers being gradually shut-out or priced out of the market – which is in line with theory. […]

  2. […] There’s an interesting essay by John Dizard (hat tip: Naked Capitalism) that argues that disintermediation – referred to by its mechanism, securitization – will become more prevalent in the future, and that this is a secular change rather than a mere transient reaction to market forces. The trouble is, the essay makes sweeping statements regarding ‘what central bankers believe’ and I don’t know on what basis the author makes these claims. I have referenced an academic paper that presents evidence that banks’ balance sheets balloon in times of stress, as the madding crowd runs to familiar, regulated entities … but eventually the crisis passes and investors wonder why they’re letting the bank take a spread on their investment. So, until I see a little more meat on the bones of Mr. Dizard’s argument, I’ll remain very skeptical that a fundamental paradigm shift has occurred. […]

  3. […] balance sheets tend to bloat in times of economic stress (this has been true for a long time – see Banks’ Advantage in Hedging Liquidity Risk) but manages to overstate his case: A reader pointed us to this Bloomberg story, “Tribune, […]

  4. […] a classic example of Banks’ advantage in hedging liquidity risk, it has been reported that corporations are drawing heavily on committed lines: Goodyear Tire […]

  5. […] entertainment facilities – and reintermediation becomes normal. This has been discussed in the post Banks Advantage in Hedging Liquidity Risk. 3. Ironically, govermental insurance is the solution but not on deposits beyond the figure a […]

  6. […] This will be another data point to support the thesis of Banks’ Advantage in Hedging Liquidity Risk. […]

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