Banks’ Private Money Creation and Market Preferences: Evidence from Banks’ Commercial Paper Issuance

Abstract

Unsecured short-term creditors of banks face the write-off risk of their securities in the event of bank runs. To prevent frequent failures, banks are required to maintain a certain level of equity within their capital structure. Thus, the short-term investors expect the disclosed equity to serve as a protective buffer providing insurance. However, an agency problem arises when banks utilize the proceeds from short-term securities issuance to artificially smooth their reported equity levels. In this study, we propose an empirical framework to observe this issue and we discover that money market funds (MMFs) act as monitors when purchasing banks' commercial papers in the primary market. Our findings illustrate that when MMFs invest in banks' short-term debts, they prefer those banks that keep their short-term debt independent from equity fluctuations, i.e., separate their liquidity management from asset-liability management. We evaluate these market preferences by observing that the banks are divided into two groups during the MMFs’ regulatory reforms that led to a decline in their demand for banks' commercial papers. Additionally, we observe that banks facing restrictions in the short-term debt market to regain market confidence signal the quality of their balance sheets through discretionary capital management. Lastly, we explore the persistence of MMFs' preferences during the Covid-19 pandemic and find that the banks' cross sectional assignment during the regulatory reforms positively predict their placement during Covid-19.

Keywords: Bank runs; short-term debt; bank capital structure; commercial paper; money market funds; regulation.

JEL Classification: G21, G23, G28, G32, D82