Banks' Advantage in Hedging Liquidity Risk: Theory and Evidence from the Commercial Paper Market

Evan Gatev and Philip E. Strahan

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: This paper argues that banks have a unique ability to hedge against systematic liquidity shocks. Deposit inflows provide a natural hedge for loan demand shocks that follow declines in market liquidity. Consequently, one dimension of bank “specialness” is that banks can insure firms against systematic declines in market liquidity at lower cost than other financial institutions. We provide supporting empirical evidence from the commercial paper (CP) market. When market liquidity dries up and CP rates rise, banks experience funding inflows, allowing them to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines without running down their holding of liquid assets. Moreover, the supply of cheap funds is sufficiently large so that pricing on new lines of credit actually falls as market spreads widen.

Date: 2003-01
New Economics Papers: this item is included in nep-fin and nep-fmk
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