10 May 2016

VoxEU: Double bank runs, liquidity risk management, and Basel III

By providing liquidity to credit line borrowers and depositors, banks are potentially exposed to simultaneous runs on their assets and liabilities. This column discusses the risk of double-bank runs, liquidity risk management by banks and the implications for the regulation of the financial sector.

A key question is whether during the crisis drawdowns were larger for banks that were more exposed to the interbank market. The richness of the Credit Register of the Bank of Italy allows authors to look at multiple credit lines that are extended simultaneously to one firm by different banks. The fact that simultaneous credit lines are common practice in Italy allows them to control for both observable and unobservable firm characteristics. Authors then tested whether firms with multiple credit lines from different banks draw down more from the banks with higher interbank funding. This would be evidence that firms run on banks with a more fragile liability structure.

Their results confirm this hypothesis. Authors find that higher pre-crisis interbank exposure was associated with larger drawdowns during the crisis. Drawdowns on banks with higher interbank exposure were stronger from more leveraged and smaller firms, and for less liquid and smaller banks. In essence, during the crisis we not only observed double bank runs, but these runs were relatively stronger for financially constrained firms and banks.

Authors evidence suggests that the run on credit lines was driven by the fear that banks with higher interbank exposure would restrict the supply of credit to firms. There was no credit supply restriction immediately after the shock in August, but in the following months, banks with higher pre-crisis interbank funding tightened the supply of loans to new applicants relatively more than other banks. They show this by looking at firms that simultaneously applied for loans to multiple banks (thus isolating the supply of credit) in the last quarter of 2007.

Risk management: Did banks foresee this risk?

Apparently yes. If one aggregates the drawdowns at the bank level, the picture that emerges is that banks with higher interbank funding did not suffer higher drawdowns than the average bank. This may seem in apparent contradiction with the statement that firms with multiple credit lines draw more from banks with higher interbank exposure. However, it is not. This has to do with how banks and firms are matched.

One way to read the above results is that banks with higher funding from the interbank market are aware of the risk of double runs, and actively manage this risk by offering credit lines to borrowers that, conditional on both unobservable and observable characteristics, are less prone to draw down in crisis times.

Authors analyse the period immediately before the crisis (the second quarter of 2007) and find that:

• Banks with higher interbank funding granted fewer credit lines in general, and even less so to financially constrained firms that tend to run more in crises;
• Conditionally on granting a line, banks with a larger exposure to the interbank market offered lower amounts.

Authors results suggest that banks manage the risk of double runs by offering credit lines selectively to borrowers, in a manner that mitigates the cross-sectional effect of drawdowns during the crisis. Interestingly, banks seem to start managing this risk in the run-up to the crisis, as we find weaker evidence of selective provision of credit lines to weaker firms in the first quarter of 2007 and in the last quarters of 2006.

Full article

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