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

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  • Evan Gatev
  • Philip E. Strahan
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    Abstract

    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. Moreover, the supply of cheap funds is sufficiently large so that pricing on new lines of credit actually falls as market spreads widen.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9956.

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    Date of creation: Sep 2003
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    Publication status: published as Gatev, Evan and Philip E. Strahan. "Banks' Advantage In Hedging Liquidity Risk: Theory and Evidence From The Commercial Paper Market," Journal of Finance, 2006, v61(2,Apr), 867-892.
    Handle: RePEc:nbr:nberwo:9956

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    Cited by:
    1. Ahmed Arif & Ahmed Nauman Anees, 2012. "Liquidity risk and performance of banking system," Journal of Financial Regulation and Compliance, Emerald Group Publishing, vol. 20(2), pages 182-195, May.
    2. Christopher F Baum & Mustafa Caglayan & Neslihan Ozkan, 2004. "The second moments matter: The response of bank lending behavior to macroeconomic uncertainty," Computing in Economics and Finance 2004 172, Society for Computational Economics.
    3. Loretta J. Mester & Leonard I. Nakamura, 2005. "Transactions accounts and loan monitoring," Working Papers 05-14, Federal Reserve Bank of Philadelphia.
    4. Jose M P Jorge, 2007. "Financial System Architecture: The Role of Systemic Risk, Added Value and Liquidity," Money Macro and Finance (MMF) Research Group Conference 2006 155, Money Macro and Finance Research Group.
    5. Iris Claus & Veronica Jacobsen & Brock Jera, 2004. "Financial Systems and Economic Growth: An Evaluation Framework for Policy," Treasury Working Paper Series 04/17, New Zealand Treasury.

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