Assets and Liabilities Correlated Fragilities

Abstract:

Banks are providers of liquidity on demand not only to the liability side but also to the asset side through credit lines. Are the liquidity risks on the two sides of the balance sheet correlated? Does this correlation induce a double liquidity squeeze during a financial crisis? We answer these questions analyzing the liquidity freeze out in the European interbank market in August 2007. For identification, we use the Italian credit register which records all credit lines and loans to firms. We match the data of bank-firm relations with firm-level and supervisory bank level data. We show within-firm evidence that, after the shock, firms with credit lines from multiple banks draw down more from the banks with higher pre-crisis exposure to the interbank market. Effects are stronger for smaller firms and for less liquid and smaller banks. Our results suggest that drawdowns are carried out by firms in anticipation of future credit supply restrictions, which we show in fact to be stronger for banks more exposed to the interbank market. However, when we analyze the aggregate bank level results without controlling for firm fixed effects or observables, we find that more interbank exposed banks do not experience higher drawdowns on their credit lines relatively to less exposed banks. This suggests that banks are able to neutralize this source of fragility by selecting borrowers who tend to draw down less during a financial crisis. In fact, we find that banks with higher interbank exposure grant less credit lines ex-ante, and especially to observable riskier firms. This evidence suggests effective ex-ante liquidity risk management by banks, and is consistent with Hanson, Shleifer, Stein and Vishny (2014) who show that financial institutions with less stable sources of funding select assets with lower liquidity risk.