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Credit Lines as Monitored Liquidity Insurance: Theory and Evidence

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  • Viral V. Acharya
  • Heitor Almeida
  • Filippo Ippolito
  • Ander Perez

Abstract

We propose and test a theory of corporate liquidity management in which credit lines provided by banks to firms are a form of monitored liquidity insurance. Bank monitoring and resulting credit line revocations help control illiquidity-seeking behavior by firms. Firms with high liquidity risk are likely to use cash rather than credit lines for liquidity management because the cost of monitored liquidity insurance increases with liquidity risk. We exploit a quasi-experiment around the downgrade of General Motors (GM) and Ford in 2005 and find that firms that experienced an exogenous increase in liquidity risk (specifically, firms that relied on bonds for financing in the pre-downgrade period) moved out of credit lines and into cash holdings in the aftermath of the downgrade. We observe a similar effect for firms whose ability to raise equity financing is compromised by pricing pressure caused by mutual fund redemptions. Finally, we find support for the model’s other novel empirical implication that firms with low hedging needs (high correlation between cash flows and investment opportunities) are more likely to use credit lines relative to cash, and are also less likely to face covenants and revocations when using credit lines.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18892.

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Date of creation: Mar 2013
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Handle: RePEc:nbr:nberwo:18892

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  1. Thomas W. Bates & Kathleen M. Kahle & René M. Stulz, 2009. "Why Do U.S. Firms Hold So Much More Cash than They Used To?," Journal of Finance, American Finance Association, American Finance Association, vol. 64(5), pages 1985-2021, October.
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Cited by:
  1. Almeida, Heitor & Campello, Murillo & Cunha, Igor & Weisbach, Michael S., 2013. "Corporate Liquidity Management: A Conceptual Framework and Survey," Working Paper Series, Ohio State University, Charles A. Dice Center for Research in Financial Economics 2013-15, Ohio State University, Charles A. Dice Center for Research in Financial Economics.

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