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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 systematic liquidity shocks. Deposit inflows provide a natural hedge 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 rates rise, banks experience funding inflows, allowing them to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines without running down their holding 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 Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 03-01.

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    Date of creation: Jan 2003
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    Handle: RePEc:wop:pennin:03-01

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    1. Marc R. Saidenberg & Philip E. Strahan, 1999. "Are banks still important for financing large businesses?," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 5(Jul).
    2. Anil K. Kashyap & Raghuram Rajan & Jeremy C. Stein, 2002. "Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit-Taking," Journal of Finance, American Finance Association, vol. 57(1), pages 33-73, 02.
    3. Anjan V. Thakor & Gregory F. Udell, 2004. "An Economic Rationale for the Pricing Structure of Bank Loan Commitments," Finance 0411053, EconWPA.
    4. Philip E. Strahan, 1999. "Borrower risk and the price and nonprice terms of bank loans," Staff Reports 90, Federal Reserve Bank of New York.
    5. Flannery, Mark J, 1994. "Debt Maturity and the Deadweight Cost of Leverage: Optimally Financing Banking Firms," American Economic Review, American Economic Association, vol. 84(1), pages 320-31, March.
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    7. Douglas W. Diamond & Raghuram G. Rajan, . "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    8. Boot, Arnoud & Thakor, Anjan V. & Udell, Gregory F., 1987. "Competition, risk neutrality and loan commitments," Journal of Banking & Finance, Elsevier, vol. 11(3), pages 449-471, September.
    9. Stewart C. Myers & Raghuram G. Rajan, 1998. "The Paradox of Liquidity," CRSP working papers 339, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    10. Froot, Kenneth A. & Stein, Jeremy C., 1998. "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, Elsevier, vol. 47(1), pages 55-82, January.
    11. Morgan, Donald P, 1998. "The Credit Effects of Monetary Policy: Evidence Using Loan Commitments," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 30(1), pages 102-18, February.
    12. Allen N. Berger & Gregory F. Udell, 1990. "Some evidence on the empirical significance of credit rationing," Finance and Economics Discussion Series 105, Board of Governors of the Federal Reserve System (U.S.).
    13. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
    14. Allen N. Berger & Gregory F. Udell, 1988. "Collateral, loan quality, and bank risk," Finance and Economics Discussion Series 51, Board of Governors of the Federal Reserve System (U.S.).
    15. Vijay Bhasin & Mark S. Carey, 1999. "The determinants of corporate loan liquidity," Proceedings 617, Federal Reserve Bank of Chicago.
    16. Fama, Eugene F., 1985. "What's different about banks?," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 29-39, January.
    17. Loretta J. Mester & Leonard I. Nakamura & Micheline Renault, 2001. "Checking accounts and bank monitoring," Working Papers 01-3, Federal Reserve Bank of Philadelphia.
    18. Chava, Sudheer & Jarrow, Robert, 2008. "Modeling loan commitments," Finance Research Letters, Elsevier, vol. 5(1), pages 11-20, March.
    19. Kanatas, George, 1987. "Commercial paper, bank reserve requirements, and the informational role of loan commitments," Journal of Banking & Finance, Elsevier, vol. 11(3), pages 425-448, September.
    20. Fredric S. Mishkin & Philip E. Strahan, 1999. "What Will Technology Do to Financial Structure?," NBER Working Papers 6892, National Bureau of Economic Research, Inc.
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    Cited by:
    1. 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.
    2. 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.
    3. 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.
    4. Loretta J. Mester & Leonard I. Nakamura, 2005. "Transactions accounts and loan monitoring," Working Papers 05-14, Federal Reserve Bank of Philadelphia.

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