Investigating Excess Reserve Accumulation and Credit Crunch in U.S. Commercial Banks Focusing on the Financial Crisis

This paper using bank-specific data for the period 1999-2009 investigates the excess reserve accumulation and credit crunch in the US commercial banking industry during the financial crisis of 2007-2008. During the sample period, the lending and reserve behaviors of large banks significantly differ from those of small banks. A large amount of excess reserve builds up in the large banks during the crisis whereas excess reserve of small banks remains stable at low levels. Large banks experience severe credit crunch during the crisis which the small banks are able to avert. Employing a two-stage model of the banking industry that treats large and small banks separately, I demonstrate that among other factors, differences in idiosyncratic uncertainties in the form of volatility of deposits and short-term funding and disparities in investments in risky trading securities can generate similar patterns observed in data. I also address the ongoing debate between two schools of thought, one of which attributes the buildup of excess reserves and reduction in interbank lending to liquidity hoarding due to precautionary motive, while the other ascribes these to an increase in counterparty risk. I demonstrate that counterparty risk plays a greater role over the short run whereas the impact of liquidity hoarding is more prominent over the long run.