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

Abstract:     
This paper argues that banks have a unique ability to hedge against market-wide 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 spreads increase, banks experience funding inflows. These allow banks to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines, without running down their holdings 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.

Number of Pages in PDF File: 42

Keywords: banking, liquidity, commercial paper

JEL Classification: G21, G12, G10

working papers series