Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Can Banks Provide Liquidity in a Financial Crisis?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Can Banks Provide Liquidity in a Financial Crisis?

Article excerpt

(ProQuest: ... denotes formula omitted.)

In financial crises of the recent past, investors often withdrew from securities markets and placed their funds into safer assets, such as U.S. Treasuries and bank deposits. During such episodes, a wide range of businesses shut out of securities markets sought to fund their operations by drawing down credit lines established with banks during normal times. Awash with funds from depositors seeking a safe haven, banks had no difficulty meeting these increased credit demands. Thus, banks helped avoid financial disruptions and business liquidations that would have occurred in the absence of a liquidity backstop.

In 2007-09, however, banks were at the center of the financial crisis. While significant risks were present in some other financial institutions, this crisis was special in that commercial banks were much more exposed to losses than in recent past crises. This key feature of the crisis casts doubt on the notion that banks are a natural source of liquidity during financial crises. Were bank deposits still viewed as a safe haven, and if not, how compromised was their ability to meet the demand for liquidity? This article examines how commercial bank deposits and lending evolved during the recent crisis compared with past episodes of financial stress.

The article concludes that the bank-centered nature of the crisis made it harder than in the past for banks to attract deposits and provide liquidity to borrowers shut out of securities markets. The first section of the article explores the main similarity and the key difference of the 2007-09 financial crisis with previous financial market disruptions. The second section reviews the theory that banks can provide liquidity when financial markets and other financial institutions cannot-and why the theory might break down in a bank-centered crisis. The third section presents new evidence, both from aggregate and individual bank data, that funds did not flow into bank deposits as robustly as in past times of stress and bank lending did not increase as much. To determine if these differences were due to the bank-centered nature of the crisis, the section also investigates whether deposits and loans increased less at banks where deposits were more likely to be viewed as unsafe.

I. COMPARING THE 2007-09 CRISIS WITH PREVIOUS FINANCIAL CRISES

The financial crisis of 2007-09 was similar to previous crises in that the need for liquidity by businesses and households was unmet by market-based sources of funding. There was also a key difference: The banking system was arguably more adversely affected by credit losses and uncertainty surrounding these losses than in recent previous crises.

The similarity of the 2007-09 and past crises

One common feature of past financial crises was a need for liquidity. Businesses, households, and other economic entities needed funds to cover day-to-day operations and investments, but found it difficult or even impossible to borrow in securities markets. The investors that supplied market funds may have suffered a major loss in one market or may have changed their beliefs about risks or uncertainty in the economy. As a result, these investors shifted funds to low-risk assets, such as U.S. Treasury bonds, in what is known as a "flight to safety." Thus, borrowers from a range of sectors became vulnerable to financing disruptions at the same time-that is, to a systemic liquidity shortage.

In such crises, the demand for liquidity usually came from nonfinancial businesses. Even large, creditworthy corporations found it difficult to place corporate bonds, raise equity financing, and even borrow short-term by selling promissory notes such as commercial paper.1 As it got difficult to renew maturing commercial paper, firms relied on borrowing at shorter maturities, such as overnight financing. Even companies with continued access to the commercial paper market faced rising costs of funding. …

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