Crises, Liquidity Shocks, and Fire Sales at Commercial Banks

Abstract

We investigate two competing explanations for commercial bank distress during financial crises: liquidity shortages and solvency concerns. If liquidity shortages cause distress, a lender of last resort can help by providing funds to banks having trouble rolling over short-term debt and facing potential fire sales. However, if financial crises mainly reduce funding for banks with existing solvency problems, then liquidity provision may not spur lending. Our analysis of commercial banks shows that funding does not typically dry up in a crisis, not even in the recent subprime crisis. Rather, weak banks face declines in capital market borrowing. Further, banks rarely resort to distressed asset sales, instead relying more on deposits and newly issued equity. Banks also engage in cherry picking when choosing assets to sell in crises, as these sales both raise cash and alleviate pressure from regulatory capital requirements.

Keywords: Commercial banks, funding shocks, liquidity shocks, fire sales, financial crisis, cherry picking, insolvency

JEL Classification: G21, G24, G28, G32, G33, E44, E58, E61