Much theory attempts to find dimensions of “bank specialness,” typically from a synergy of combining deposits with loans. Banks’ role as delegated monitor explains why they tend to hold large and well diversified loan portfolios, and why they tend to fund themselves mostly with debt (Diamond, 1984). Bank deposits – their main source of debt – tend to be short term and subject to a ‘sequential service constraint’, meaning that priority of payment comes on a first-come, first-served basis. This unique capital structure stems from bank-loan opaqueness. Loans make “bad” collateral because outsiders can not value them; by subjecting themselves to the possibility of a run, banks increase their borrowing capacity against their loans (Calomiris and Kahn, 1991; Flannery, 1994; Diamond and Rajan, 2001).
Fama (1985) argues that liquidity production helps explain ‘what’s different about banks’. Private information from the business checking account gives banks an advantage in lending over other intermediaries. Banks provide liquidity not only to demand depositors, however, but also to borrowers via lines of credit and un-drawn loan commitments (we use these terms interchangeably). Both contracts allow customers to receive cash on demand. The liquidity insurance role of banks exposes them to the risk that they will have insufficient cash to meet random demands from their depositors or borrowers. This paper shows that banks reduce their liquidity risk by combining transactions deposit with loan commitments, thus helping explain a key feature of the industry.
Our point of departure is the model presented by Kashyap, Rajan and Stein (2002), hereafter KRS, who explain why banks tend to combine transactions deposits with loan commitments based on a risk-management motivation: as long as the demand for liquidity from depositors through the checking account is not highly correlated with liquidity demands from borrowers, an intermediary will be able to reduce its need to hold cash by serving both customers. Thus, their model yields a diversification synergy between demand deposits (or transactions deposits more generally) and loan commitments. As evidence, KRS report a positive correlation across banks between unused loan commitments and transactions deposits. The correlation is robust to variations in the definition of loan commitments, to bank size, and is also consistent across time. KRS do not, however, test the key implication of their model – the idea that by exposing themselves to asset-side and liability-side liquidity risks simultaneously, banks can enjoy a diversification, or risk-reducing, synergy.
We test the basic premise of the KRS model – that liquidity risks stemming from the two fundamental businesses of banking yield a diversification benefit. The results suggest that bank risk, measured by stock return volatility, increases with unused loan commitments, reflecting asset-side liquidity risk exposure. This increase, however, is mitigated by transactions deposits. In fact, risk does not increase with loan commitments for banks with high levels of transactions deposits.
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