Asset-side Bank Runs and Liquidity Rationing: A Vicious Cycle

Abstract

This paper studies financial vulnerability in a dynamic banking model with credit line runs on the asset side of a bank’s balance sheet. I show that a strategic complementarity between bankers and borrowers arises from the contingency in credit lines and costly intermediation. Panic drawdowns by credit line borrowers and liquidity rationing by bankers reinforce each other and lead to a vicious cycle. Using data from U.S. banks, I estimate an infinite-horizon model in which banker-borrower strategic complementarity amplifies shocks on intermediation costs. The amplification channel accounts for one-third of the overall credit contraction during the 2008-09 crisis.

Keywords: Credit lines, liquidity rationing, strategic complementarity, amplification channel.

JEL Classification: E44, E50, G01, G21, G28