Aggregate Risk and the Choice between Cash and Lines of Credit

We argue that a firm's aggregate risk is a key determinant of whether it manages its future liquidity needs through cash reserves or bank lines of credit. Banks create liquidity for firms by pooling their idiosyncratic risks. As a result, firms with high aggregate risk find it costly to get credit lines from banks and opt for cash reserves in spite of higher opportunity costs and liquidity premium. We verify our model's hypothesis empirically by showing that firms with high asset beta have a higher ratio of cash reserves to lines of credit, controlling for other determinants of liquidity policy. This effect of asset beta on liquidity management is economically significant, especially for financially constrained firms; is robust to variation in the proxies for firms' exposure to aggregate risk and availability of credit lines; works at the firm level as well as the industry level; and is significantly stronger in times when aggregate risk is high. Consistent with the channel that drives these effects in our model, we find that firms with high asset beta face higher spreads on bank credit lines.