Credit Lines as Monitored Liquidity Insurance: Theory and Evidence

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.