A Crisis of Banks as Liquidity Providers

Abstract

Can banks maintain their advantage as liquidity providers when exposed to a financial crisis? While banks honored their credit lines drawn by firms during the 2007-09 crisis, this provision of liquidity by banks was only possible because of explicit, large support from the government and government-sponsored agencies. At the onset of the crisis, aggregate deposit inflows into banks weakened and their loan-to-deposit shortfalls widened. These patterns were pronounced at banks exposed to greater undrawn commitments. Such banks sought to attract deposits by offering higher rates, but the resulting private funding was insufficient to cover loan-to-deposit shortfalls and they reduced new credit.

Keywords: Liquidity risk, Solvency risk, Financial crisis, Flight to safety

JEL Classification: E4, G01, G11, G21, G28