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Credit Lines as Monitored Liquidity Insurance: Theory and Evidence

  • Heitor Almeida

    (University of Illinois)

  • Filippo Ippolito

    (Universitat Pompeu Fabra)

  • Ander Perez

    (Universitat Pompeu Fabra)

  • Viral Acharya

    (New York University)

Registered author(s):

    Recent empirical and survey evidence on corporate liquidity management suggests that bank credit lines do not offer fully committed liquidity insurance, and that they are frequently used to finance future growth opportunities rather than for precautionary motives. In this paper, we propose and test a theory of corporate liquidity management that is consistent with these findings. We argue that a corporate credit line can be understood as a form of monitored liquidity insurance, which controls illiquidity-seeking behavior by firms through bank monitoring and credit line revocation. In addition, we allow firms to demand liquidity not to hedge against negative liquidity shocks, but to help finance future growth opportunities. We show that bank monitoring and credit line revocation play less of a role for such firms, because the nature of their liquidity demand reduces their incentives to engage in illiquidity-seeking behavior. Thus, firms that have low hedging-needs (e.g., high correlation between cash flows and investment opportunities) can access fully committed credit lines that dominate cash holdings as an optimal liquidity management tool. We use a novel dataset on corporate credit lines to provide empirical evidence that is consistent with the predictions of the model. The evidence suggests that credit line users have lower liquidity risk than firms that use cash for liquidity management. In addition, firms with low hedging-needs are more likely to use credit lines for liquidity management. Credit line covenants and covenant violations are less common when the credit line user has low hedging needs.

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    File URL: https://www.economicdynamics.org/meetpapers/2012/paper_823.pdf
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    Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 823.

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    Date of creation: 2012
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    Handle: RePEc:red:sed012:823
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    1. Bates, Thomas W. & Kahle, Kathleen M. & Stulz, Rene M., 2007. "Why Do U.S. Firms Hold So Much More Cash Than They Used To?," Working Paper Series 2006-17, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    2. Shockley, Richard L & Thakor, Anjan V, 1997. "Bank Loan Commitment Contracts: Data, Theory, and Tests," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 517-34, November.
    3. Cem Demiroglu & Christopher M. James, 2010. "The Information Content of Bank Loan Covenants," Review of Financial Studies, Society for Financial Studies, vol. 23(10), pages 3700-3737, October.
    4. Acharya, Viral V & Almeida, Heitor & Campello, Murillo, 2005. "Is Cash Negative Debt? A Hedging Perspective on Corporate Financial Policies," CEPR Discussion Papers 4886, C.E.P.R. Discussion Papers.
    5. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
    6. Holmström, Bengt & Tirole, Jean, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," IDEI Working Papers 40, Institut d'Économie Industrielle (IDEI), Toulouse.
    7. Dittmar, Amy & Mahrt-Smith, Jan & Servaes, Henri, 2002. "Corporate Liquidity," CEPR Discussion Papers 3499, C.E.P.R. Discussion Papers.
    8. Steven Drucker & Manju Puri, 2009. "On Loan Sales, Loan Contracting, and Lending Relationships," Review of Financial Studies, Society for Financial Studies, vol. 22(7), pages 2635-2672, July.
    9. Ran Duchin, 2010. "Cash Holdings and Corporate Diversification," Journal of Finance, American Finance Association, vol. 65(3), pages 955-992, 06.
    10. Michael L. Lemmon & Michael R. Roberts & Jaime F. Zender, 2008. "Back to the Beginning: Persistence and the Cross-Section of Corporate Capital Structure," Journal of Finance, American Finance Association, vol. 63(4), pages 1575-1608, 08.
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