The rise of the commercial paper market, which resumed following the demise of the Penn Central Railroad in the early 1970s, followed by the growth of the junk bond market in the 1980s and 1990s, has seemingly reduced the role of banks in providing financing to large businesses (Mishkin and Strahan, 1998). This much-remarked-upon evolution away from banks and toward the securities markets, though, has not rendered banks irrelevant (Boyd and Gertler, 1994). While they do provide less funding than before, banks remain important, even for large firms, as the “liquidity provider of last resort.” This liquidity insurance role is notable in the commercial paper market, where issuers invariably secure a backup line of credit from their bank as protection against market pullbacks. Banks have also traditionally provided liquidity insurance in the form of loan commitments to many classes of borrowers. In the case of the commercial paper backup lines, these contracts allow firms to borrow (or “take down”) up to a pre-determined amount of funds at a fixed spread over a safe market benchmark interest rate such as LIBOR. This liquidity insurance softens the blow of reduced liquidity, where liquidity can be defined as the firm’s ability to access the capital markets at attractive (fair) prices.
Why do commercial banks, as opposed to some other kind of financial institutions, provide this liquidity insurance? In this paper, we argue that banks can provide firms insurance against market-wide liquidity shocks at lower cost than other financial intermediaries because deposit inflows provide a hedge for loan demand shocks. Figure 1 illustrates our main argument graphically. During normal times (high liquidity), funds flow directly from investors to firms (broken line in Figure 1). Because banks are viewed as a safe haven by investors, funding tends to become available to them during periods of market stress (low liquidity), just when borrowers want to draw funds from their loan commitments. Hence, the funding flows within a bank complement each other, with deposit inflows serving as a hedge for outflows from loan commitment take-downs (solid lines in Figure 1). Because of this hedge, banks can offer the lowest-cost insurance against a systematic shock to liquidity. The banks’ ability to sell liquidity insurance more cheaply than other financial institutions provides an explanation for the viability of their business in this particular market.
Our argument complements Kashyap, Rajan and Stein (2002), who propose a risk-management motive as a defining characteristic of a commercial bank: a financial intermediary that combines demand deposits with loan commitments and lines of credit (we use these two terms synonymously). In effect, banks offer liquidity to both households and firms with these two products. As long as the demand for liquidity from depositors and borrowers is not too highly correlated, the intermediary will pool these two classes of customers together to conserve on its need to hold costly liquid assets – the buffer against unexpected deposit withdrawals and loan take downs. Our argument extends the KRS rationale to highlight an additional specialty of banks – their unique ability to hedge against systematic liquidity shocks. As a result, banks can insure firms against market-wide declines in the availability of liquidity at lower cost than other institutions. While the KRS risk-management argument is quite general, it applies to any firm that can diversify efficiently across different lines of business. Our contribution is to uncover a new dimension of bank “specialness” that has not been emphasized in the literature.
Section II below provides some background by describing banks’ liquidity insurance role in the commercial paper market. The main argument is presented Section III, where a simple model shows how the correlation between a lender’s funding cost and the availability of market liquidity affects its ability to price this insurance. In a competitive equilibrium, the price of loan commitments varies negatively with the covariance between the cost funds to the lender and the availability of market liquidity. This is the main testable implication of the model.
In Sections IV and V, we show empirically that bank fund costs decrease when market liquidity becomes scarce, where liquidity is measured by the difference between the commercial paper rate to high-grade borrowers and the Treasury Bill rate (the “paper-bill spread”). We provide three pieces of supporting evidence. First, we show that bank asset growth increases in response to widening of spreads in the commercial paper market, controlling for the overall level of interest rates. Moreover, the increase in assets occurs not only in the loan and C&I loan portfolio, but also among banks’ holdings of liquid assets (cash and securities). Thus, rather than running down their buffer of liquid assets in response to market shocks, as banks would do in the face of unexpected increases in loan demand alone, banks increase their holding of liquid assets. This increase in liquid assets is strong evidence of greater availability of funding to banks. Second, we show that the quantity of assets funded with deposits (particularly transactions deposits) increases with the paper-bill spread, reflecting the increased availability of deposit finance during periods of high spreads. Third, we test how the funding costs of banks versus finance companies changes with the commercial paper spread. We find that yields on bank-issued paper (i.e., large negotiable CDs) decreases with the commercial paper spread, whereas the yields on finance-company-issued paper do not. This differential response to commercial paper shocks is our most direct evidence that banks have a comparative advantage over their closest competitor in offering liquidity insurance.
In our last set of results, we use bank-level panel data to demonstrate that the increase in lending that occurs with commercial paper market tightness is concentrated at banks with a high level of pre-existing loan commitments. In contrast, the increase in liquid assets occurs at banks across the board, regardless of their level of pre-existing loan commitments. Similarly, we find that inflows of funds do not reflect a banks own financial risk, as measured by its capital-asset ratio. Taken together, these results suggest that banks in general experience funding inflows during periods of high spreads. From this finding we draw the tentative conclusion that implicit backing of bank liabilities by the government explains their ability to raise cheap funds when other financial institions can not, thereby explaining banks advantage in offering insurance against market-wide declines in liquidity.
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Banks’ Advantage In Hedging Liquidity Risk: Theory And Evidence From The Commercial Paper Market
