Crises, Liquidity Shocks, and Fire Sales at Commercial Banks

By Boyson, Nicole; Helwege, Jean et al. | Financial Management, Winter 2014 | Go to article overview

Crises, Liquidity Shocks, and Fire Sales at Commercial Banks


Boyson, Nicole, Helwege, Jean, Jindra, Jan, Financial Management


If liquidity shortages cause financial crises, a lender of last resort can provide funds to banks facing potential fire sales. However, if funding problems primarily occur at banks with existing solvency problems, then government liquidity programs may not spur bank lending. We find that commercial bank funding does not typically dry up in a crisis, not even during the subprime crisis. Rather, weak banks are more likely to borrow less. Furthermore, banks rely more on deposits and newly issued equity than fire sales. When they do sell assets, they cherry pick assets in order to alleviate pressure from capital regulations.

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What causes a financial crisis to snowball into major problems for the whole economy: liquidity or insolvency? During the subprime crisis, regulators frequently alluded to "frozen debt markets" and offered a host of liquidity facilities to promote bank lending to nonfinancial firms. As in past crises, the Federal Reserve ("Fed") played the role of "lender of last resort" and attempted to reduce frictions in capital markets that could hinder banks' access to funds.

Extraordinary liquidity programs are justified if crises inhibit capital markets from appropriately allocating credit. However, these programs may not work if credit allocation declines for other reasons. In particular, if declining asset values drive some banks closer to insolvency, then capital market participants may not be willing to provide funding to these banks in any circumstances. Further, if extending emergency credit to banks props up inefficient institutions that are best left to fail, these programs may even be counterproductive in the long run. Without understanding the underlying cause of capital market disruptions, simply providing liquidity may not address the underlying factors and avert a full blown recession.

In this paper, we investigate which factor, liquidity or insolvency, is more important for financial crises. In particular, we examine bank borrowing to determine if money is scarce across the board, as liquidity shock explanations imply, or if capital market lenders cut off particularly weak banks due to credit concerns. Further, to the extent that banks face debt shortfalls, we examine their strategies for replacing the lost funds. Under the liquidity hypothesis, debt markets tighten, forcing banks to sell assets. However, under the solvency hypothesis, nearly insolvent banks will instead issue equity, cut dividends, and raise deposits before selling assets. For banks that must sell assets, the solvency hypothesis predicts that banks will cherry pick their assets, thus improving their equity capital. Cherry picking is a regulatory arbitrage strategy of realizing gains on appreciated assets while avoiding selling assets with declining market values. Only after exhausting all of these options will banks resort to fire sales (i.e., selling assets at a realized loss).

We use data on commercial banks from 1980 to 2008 to evaluate these two explanations of financial crises. Most commercial banks do not experience declines in funding during crises, which runs counter to the main element of liquidity shock theories. Banks that usually rely on capital markets to fund their loans continue to issue new debt during crises, although at a slower pace than during booms. This result holds for the recent subprime crisis, even after controlling for funding from the Fed and the Federal Home Loan Bank (FHLB). Importantly, the majority of banks that need funds in a crisis are not troubled by illiquid markets, but rather by their own balance sheets. They enter the crisis in worse financial condition than other banks. Moreover, when banks experience difficulties in rolling over debt, their troubles do not usually lead to asset sales. Instead, banks rely more on deposits, issue equity, and sell off noncore assets at prices that improve, not deplete, their reported capital positions. Overall, we conclude that financial crises are defined primarily by insolvency concerns rather than by frozen debt markets. …

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