Banks' Advantage in Hedging Liquidity Risk: Theory and Evidence from the Commercial Paper Market




    Search for more papers by this author
    • Gatev is at Boston College, and Strahan is at Boston College, the National Bureau of Economic Research, and the Wharton Financial Institutions Center. We thank Viral Acharya, Pierluigi Balduzzi, Daniel Covitz, Wayne Ferson, Mark Flannery, Ed Kane, Anil Kashyap, Arvind Krishnamurthy, George Pennacchi, Jeff Pontiff, Jeremy Stein, and an anonymous referee for helpful comments, as well as seminar participants at the 2003 American Finance Association Annual Meeting, Boston College, the National Bureau of Economic Research, the Western Finance Association 2003 Annual Meeting, and the Federal Reserve banks of New York and Chicago.


Banks have a unique ability to hedge against market-wide liquidity shocks. Deposit inflows provide funding for loan demand shocks that follow declines in market liquidity. Consequently, banks can insure firms against systematic declines in liquidity at lower cost than other institutions. We provide evidence that when liquidity dries up and commercial paper spreads widen, banks experience funding inflows. These flows allow banks to meet loan demand from borrowers drawing funds from commercial paper backup lines without running down their holdings of liquid assets. We also provide evidence that implicit government support for banks during crises explains these funding flows.