Balance Rights and Responsibilities in Liquidity Supply and Demand Contracts

Abstract

We propose three assumptions to model a fair liquidity contract between demand and supply. The first two assumptions are active banks and uncertain corporate revenues. In Assumption Three, we allow either side to maximize its long-term assets. Active banks decline requests if the income-generating capacity of borrowers is of concern. Due to uncertain revenues, some entrepreneurs are exposed to unexpected liquidity shortages when operating their routine business. We model convergent decisions from the liquidity supply and demand sides through extensive-form games. Our model can explain two stylized facts. Why do some, but not all, companies have access to credit lines? Why does a company have access to term loans or convertible debt instead? Our empirical analysis focuses on two credit line questions. How do we explain the distribution of credit line contracts? Companies with sufficient internal liquidity do not apply for credit line access. Banks unconditionally deny liquidity demand from companies that are small or generate low operating income or volatile cash flows. We also document conditional contract approvals. Credit lines substitute for cash holdings or cash flows. The second question satisfies the identification hurdle. We document the demand-side explanations for drawdowns of regular borrowers with credit line contracts in 2008 and 2009? By contract obligations, borrowers decide their drawdown amounts, and banks must honor drawdown requests. We present quantitative and qualitative evidence from 10-K to support the demand side story. The regression results confirm that fractional drawdowns are sufficient to neutralize the internal liquidity shortages of regular borrowers.

Keywords: Fair rights and responsibilities, liquidity supply and demand, active banks,\\uncertain operating income, demand side story

JEL Classification: G21, G30