Liquidity Management and Real Credit Supply: Evidence from Bank Participation in Financial Markets

Abstract

For the aggregate bank sector in the U.S., cash flows from participation in financial markets (trading activities) are counter-cyclical, while cash flows from lending activities are pro-cyclical. We argue that counter-cyclical cash flows from trading activities reflects banks’ efforts to tailor trading activities to provide liquidity during economic contractions, when such liquidity is most needed. Consequently, banks that effectively manage liquidity risk using trading activities can provide credit at a lower cost. Effectiveness of liquidity risk management is measured by the correlation between cash flows from trading and lending activities. We provide evidence that for the aggregate bank sector when correlation increases credit supply subsequently falls. Using a panel data-set for a cross-section of bank holding companies, we show that effective liquidity risk management is associated with higher credit supply, higher profitability, and lower volatility of cash flows. Our study contributes to the contemporary regulatory debate regarding restrictions on banks’ participation in financial markets by highlighting a channel through which trading activities can impact traditional lending activities.