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Banks' Advantage in Hedging Liquidity Risk: Theory and Evidence from the Commercial Paper Market

  • Evan Gatev
  • Philip E. Strahan
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    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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    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
    Date of revision:
    Handle: RePEc:wop:pennin:03-01
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