Banks' responses to funding liquidity shocks: Lending adjustment, liquidity hoarding and firesales

Abstract

The crisis of 2007-2009 has shown that financial market turbulencecan lead to huge funding liquidity problems for banks. This paperprovides empirical evidence on banks' responses to market fund-ing shocks, using data of seventeen of the largest Dutch banks overthe period January 2004-April 2010. The dynamic interrelationsamong instruments of bank liquidity management are modelledin a panel Vector Autoregressive (p-VAR) framework. Orthogonal-ized impulse responses reveal that banks respond to a negativefunding liquidity shock in a number of ways. First, banks reducelending, especially wholesale lending. Second, banks hoard liquid-ity in the form of liquid bonds and central bank reserves. Third, banks conduct fire sales of securities, especially equity. Fourth, firesales are triggered by liquidity constraints rather than by solvencyconstraints. Finally, there is some causality running from fire salesof equity to wholesale lending and liquidity hoarding.