Liquidity Insurance Research Articles

Buy now, pay later as liquidity insurance: Evidence from an early experiment in China

This study explores the liquidity insurance role of Buy Now, Pay Later (BNPL). As a complementary study to Bian et al. (2023), we provide institutional background and mechanism analysis of BNPL's consumption-boosting effects. Since a significant consumption boosting effect exists even for individuals who did not draw on the BNPL credit line, we argue that BNPL provides liquidity insurance by releasing preexisting precautionary liquidity reserves into consumption. We also explore several robustness checks and heterogeneity analyses.

Bank Lines of Credit as a Source of Long-Term Finance

AbstractHand-collecting credit line drawdowns that firms classify as long-term debt, we first document how long-term drawdowns rise with high investment needs or weak external capital market conditions. Nearly all drawdown proceeds finance long-term investment, including M&A activity. Unrated and lower-rated firms rely more on long-term drawdowns than high or very poorly rated firms. We further find that credit lines have tighter covenants than terms loans. Drawdowns are repaid fairly quickly and often refinanced with other long-term debt. Our findings support the monitored liquidity insurance theory of credit lines and highlight that long-term drawdowns act as a valuable bridge financing mechanism.

Relationship Lending and Employment Decisions in Firms’ Bad Times

AbstractUsing firm-level survey information, we investigate whether relationship lending affects firms’ employment decisions in the face of negative sales shock. We find that firms with a durable relationship with their main bank display significantly less employment growth sensitivity to such shocks, especially where these are transitory. The result is stronger for younger and smaller firms that benefit from tighter bank-firm relationships, and for firms in sectors or economic environments where the costs of employment adjustment are greater. Our findings indicate that relationship lending provides liquidity insurance to firms to meet their demand for labor hoarding.

Wealth inequality, systemic financial fragility and government intervention

AbstractDoes wealth inequality make financial crises more likely? If so, how can a government intervene, and how does this affect the distribution of resources in the economy? To answer these questions, we study a banking model where strategic complementarities among wealth-heterogeneous depositors trigger systemic self-fulfilling runs. In equilibrium, higher wealth inequality increases directly the incentives to run of the poor, and indirectly those of the rich via higher bank liquidity insurance, thus increasing the probability of a systemic self-fulfilling run overall. A government intervention on illiquid but solvent banks redistributes resources towards the poor and makes systemic self-fulfilling runs less likely.

Banks’ liquidity provision and panic runs with recursive preferences

How important is it to distinguish relative risk aversion (RRA) from the intertemporal elasticity of substitution (IES) to study banks’ provision of liquidity insurance and the effectiveness of deposit freezes against depositors’ panic runs? To answer these questions, I develop a Diamond–Dybvig model of banking in which depositors feature recursive preferences. In equilibrium, banks provide liquidity insurance, and a time-consistent deposit freeze prevents panic runs, only if depositors’ preferences for an early resolution of uncertainty are sufficiently strong, i.e. if RRA is sufficiently larger than the inverse of IES.

Wholesale funding runs, global banks' supply of liquidity insurance, and corporate investment

Using supervisory data on the U.S. branches of foreign banks and their syndicated loans, we show that the branches of euro-area banks suffered a liquidity shock in the form of reduced access to wholesale funding from U.S. money market funds during the European sovereign debt crisis. Affected branches cut lending to U.S. firms mostly in the form of revolving credit and along the extensive margin, as increased funding from their parents only partially offset the liquidity shortfall. This shock was amplified by the reaction of exposed U.S. firms, which responded to the loss of credit lines by reducing investment and building up cash reserves. Our findings highlight the impact of funding stress encountered by global banks on firms' investment and precautionary savings.

Credit Lines and the Liquidity Insurance Channel

AbstractWe suggest a new mechanism—the liquidity insurance channel—based on the widespread reliance of high credit quality firms on bank credit lines for liquidity management. Our model matches the patterns of usage of loans and credit lines in the cross‐section of firms and defines the conditions under which shocks to bank health affect primarily low or high credit quality firms. Our framework can explain why credit line origination is more cyclical than loan origination. Overall, we uncover a novel interaction between bank health and economic activity through the provision of bank credit lines to high credit quality firms.

Customer risk and the choice between cash and bank credit lines

I use a matched buyer–supplier sample of U.S. industrial firms to investigate the impact of customer risk on suppliers' choice between cash and credit lines. I show that customer risk decreases the reliance on bank-managed liquidity insurance relative to cash. I also find evidence indicating that firms actively shy away from credit lines in response to customer risk to maximize the future availability of their liquidity reserves. Consistently, my findings suggest that high-customer-risk firms are particularly more likely to be subject to (stricter) borrowing base provisions, which tie the value of a credit line to that of some eligible collateral (notably accounts receivable). I also find that steeper credit line spreads alone cannot explain firms' response to customer risk. These results highlight how customer–supplier relationships affect the precautionary demand for liquidity, and significantly shape corporate financial decisions.

Liquidity Insurance vs. Credit Provision: Evidence from the COVID-19 Crisis

We study the link between the unexpected surge in credit line drawdowns in March-April 2020 and banks’ subsequent lending decisions. We find that banks with larger ex ante credit line portfolios, thus higher risk of drawdowns, tightened loan supply and the terms on new loans, especially to small firms. Exposed banks were also more reluctant to participate in the Paycheck Protection Program. The main mechanism was a reduction of risk tolerance rather than immediate balance sheet constraints. Our findings highlight the tension between banks providing liquidity insurance through precommitted credit while simultaneously sustaining lending to the broader economy during crises.

Hedge Fund Leverage: The Role of Moral Hazard and Liquidity Insurance

Hedge Fund Leverage: The Role of Moral Hazard and Liquidity Insurance

Banks' Liquidity Provision and Panic Runs with Recursive Preferences

How important is it to distinguish relative risk aversion (RRA) from the intertemporal elasticity of substitution (IES) to study banks' provision of liquidity insurance and the effectiveness of deposit freezes against depositors' panic runs? To answer these questions, I develop a Diamond-Dybvig model of banking in which depositors feature recursive preferences. In equilibrium, banks provide liquidity insurance, and a time-consistent deposit freeze prevents panic runs, only if depositors' preferences for an early resolution of uncertainty are sufficiently strong, i.e if RRA is sufficiently larger than the inverse of IES.

Economic policy uncertainty and the supply of business loans

Abstract Using a Vector Autoregressive framework of analysis, we show that banks contract their supply of business credit in response to an exogenous increase in economic policy uncertainty. This contraction takes two main, distinct forms. On the one hand, banks restrict their supply of spot funds, which we document using flows of loans and term loan originations. On the other hand, banks also curtail their provision of liquidity insurance, reducing the amount of new credit lines and embedding in them a pricing structure that reduces the probability of borrowers drawing down on the lines. At the peak of the responses, we find that a one-standard-deviation increase in EPU causes a contraction in the supply of business loans between 3 and 5% on the extensive margin.

Bank Syndicates and Liquidity Provision

We provide evidence that credit lines offer liquidity insurance to borrowers. Borrowers are able to extensively use their credit lines in recessions and ahead of credit line cuts. In fact drawdowns and changes in drawdowns predict internal credit rating downgrades and credit line cuts, suggesting substantial liquidity access before credit line cuts. Credit line cuts are concentrated on borrowers who do not use credit lines, and when they occur they still leave borrowers with funds to draw down. Building on this evidence, we develop a model where syndicates faced with liquidity shocks continue to support credit line commitments due to the continuation value of their relationship with borrowers. Our model yields a set of predictions that find support in the data, including the substantial increase in the lead bank's retained loan share and in the commitment fees on the credit lines issued during the financial crisis of 2008-09. Consistent with the model, credit lines with higher expected drawdown rates pay higher commitment fees, and lead banks often increase their credit line investments in response to the failure of syndicate members, reducing borrowers' risk exposure to bank failures.

Liquidity Insurance with Market Information

Abstract This paper studies how market signals—such as stock prices—can help alleviate the severity of the asymmetric information problem in credit and liquidity management. Asymmetric information hinders the ability of borrowers (firms, investment banks, etc.) to undertake profitable investment opportunities and to insure themselves against liquidity shocks. I show that on the equilibrium path creditors do not learn anything from market signals because they can use a menu of contracts to screen the different types of borrowers. However, by conditioning liquidity insurance on ex post price signals, creditors are able to provide the borrowers with better incentives for truth telling. At the same time, prices depend on the liquidity that creditors offer to the borrowers. This two-way feedback impacts the design of the optimal contract and potentially generates multiple equilibria in financial markets.

Brother, Can You Spare a Dollar? Designing an Effective Framework for Foreign Currency Liquidity Assistance

The core principles of financial crisis management call upon central banks to lend freely, against good quality collateral, and at a penalty rate of interest, to solvent but illiquid banks and other financial institutions during periods of widespread panic and instability. While often taken for granted, these principles were designed for a world in which central banks have the capacity to create money denominated in the same currency as the one in which domestic banks and other financial institutions issue deposits and other short-term liabilities. Unfortunately, this is not the world in which we live. The application of these principles is far from straightforward in a world where financial institutions rely on short-term foreign currency liabilities as a source of financing. This is the world of the Eurodollar market. The global financial crisis vividly illustrated the potential systemic risks arising from the existence of a large Eurodollar market. Faced with a systemic foreign currency liquidity crisis, central banks struggled to secure access to the foreign currency reserves needed to provide emergency liquidity assistance to their domestic banking systems. In response, the U.S. Federal Reserve and other major central banks established a network of swap lines designed to provide foreign currency liquidity assistance to the international financial system. The central bank swap lines have been hailed as one of the most important and effective policy responses to the financial crisis. However, while it may be tempting to view them as an effective prophylactic against future foreign currency liquidity crises, the current structure of the swap lines fails to establish truly credible international commitments or constrain the moral hazard problems stemming from this ambitious state sponsored liquidity insurance. This Article examines the unique policy challenges posed by foreign currency liquidity problems, along with how to build a more effective framework for the provision of foreign currency liquidity assistance.

Quid Pro Quo: Liquidity Insurance in Dealer-Fund Network

Author(s): Chen, Luming | Advisor(s): Sun, Zheng | Abstract: Using a novel security-level data from SEC on US tri-party repo, this paper investigates how trading relationship impacts liquidity provision within the dealer-fund repo network. This paper documents a unique repo rate dynamic: in normal times, funds charge a premium to dealers with whom they have the strongest trading relationship; in market-wide liquidity shocks, these dealers are rewarded with lower repo rate markup and better immediacy. I exploit the 2016 Money Market Fund Reform as an exogenous liquidity shock to establish a liquidity insurance mechanism. As liquidity insurers are not easily replaceable, shown in the unexpected liquidation case of Charles Schwab Sweep Funds, costly search incentivizes dealers to engage in such stable quid pro quo relationship with money market funds.

The Side Effects of Shadow Banking on Liquidity Provision

Shadow banks had a negligible presence in the US corporate loan market in the 1990s, but by 2016 they funded about 45% of the outstanding corporate term loans. Consistent with banking theories on liquidity provision, shadow banks remained absent from the credit line business. Nonetheless, they had a negative impact on the liquidity insurance provided by credit lines. The arrival of shadow banks increased competition in the term loan business and triggered a substitution of traditional term loans that amortize linearly with bullet loans that are paid at maturity. These changes led to the exit of banks, in particular those with lower risk appetite, not only from term loans but also from credit lines that are part of the deals containing those term loans. As a result, credit line syndicates have become more concentrated and funded by riskier banks, thereby, reducing the liquidity insurance they offer to corporations.

Money, Banking, and Financial Markets

AbstractThe fact that money, banking, and financial markets interact in important ways seems self-evident. The theoretical nature of this interaction, however, has not been fully explored. To this end, we integrate the Diamond (1997, Journal of Political Economy105, 928–956) model of banking and financial markets with the Lagos and Wright (2005, Journal of Political Economy113, 463–484) dynamic model of monetary exchange—a union that bears a framework in which fractional reserve banks emerge in equilibrium, where bank assets are funded with liabilities made demandable in government money, where the terms of bank deposit contracts are affected by the liquidity insurance available in financial markets, where banks are subject to runs, and where a central bank has a meaningful role to play, both in terms of inflation policy and as a lender of last resort. Among other things, the model provides a rationale for nominal deposit contracts combined with a central bank lender-of-last-resort facility to promote efficient liquidity insurance and a panic-free banking system.

Effect of Financing Costs and Constraints on Real Investments: The Case of Inventories

This paper studies the effects of bank credit availability, trade credit and the capital cost on inventory decisions. There are two competing theories on the effect of bank credit lines on investments. While one (Lins et al. 2010) suggests that the primary role played by undrawn credit is to finance new opportunities, the other (Acharya et al. 2014) suggests that undrawn credit serves primarily as a bank monitored liquidity insurance. We attempt to resolve these two conflict views in the context of inventory investments. Using empirical data, we show that the primary role of undrawn credit depends on the individual firm’s financial status. When a firm is financially constrained, its inventory decisions are linked to the additional bank credit available to the firm—echoing the insurance nature of bank credits. On the other hand, when a firm is financially healthy, two other inventory financing factors play more significant roles than undrawn credits. For financially healthy firms, inventory investments are significantly negatively related to the financial cost of inventory and positively related to the credit offered by suppliers. Additionally, we study the financial crisis of 2007–2008 as a systematic shock in the credit market to identify the effects of a firm’s financial credits. We show that during the financial crisis, the inventory turnover and working capital levels of US retailers were related to the availability of bank credit. However, immediately after the crisis, the evidence demonstrates the positive relationship between firms’ inventory level and the trade credit they are offered.

Regional Liquidity Shocks, Financial Markets, and Central Bank Policy

Financial markets and financial intermediation may be competing mechanisms in the provision of liquidity insurance and their co-existence may adversely impact risk-sharing. The question studied here is what is the optimal central bank policy when there is private information about liquidity shocks and alternative insurance mechanisms. Regions are subject to idiosyncratic liquidity demand shocks and households are subject to liquidity preference shocks, where both types of shocks are private information. In the absence of central bank intervention, competitive equilibria with interbank lending and financial intermediation are inefficient relative to the first-best, as are competitive equilibria when financial intermediation, interbank and financial markets co-exist, often resulting in over-investment in the long-term asset. The heterogeneous regions share a common central bank, which can implement welfare-improving policies by acting as a mechanism designer. Constrained competitive equilibria can support the first-best allocation when the central bank uses two policies: (i) a simple portfolio restriction in the form of a liquidity floor, creating a wedge between the endogenous marginal rate of transformation and the interbank lending rate; (ii) allowing intermediary liabilities to be negotiable, or to serve as collateral in loans or repurchase agreements. Both policies play a critical role in restoring efficiency. Although the central bank can prevent trading of intermediary liabilities in local financial markets, it is not optimal to do so. The issues studied here might arise, for example, in a banking union with a common central bank or a large country with regional liquidity shocks.