Liquidity Insurance vs. Credit Provision: Evidence from the COVID-19 Crisis

Abstract

We exploit the unexpected surge in corporate credit line drawdowns in the early phase of the COVID-19 pandemic as a bank balance sheet shock and examine the impact on banks’ lending decisions. We show that banks with larger ex-ante credit line portfolios---and hence higher risk of drawdowns---reported tightening lending standards on new C\&I loans to small and large firms, curtailed the supply of large syndicated loans, and reduced the number and volume of small business loans since March 2020. Exposed banks were also less likely to participate in and grant loans through government-sponsored credit programs such as the Paycheck Protection Program and the Main Street Lending Program. We document that the main mechanism by which the risk of credit line drawdowns likely affected banks' lending decisions was a reduction of risk tolerance rather than balance sheet (liquidity and capital) constraints. Our findings suggest that tension may arise during crises between banks providing liquidity insurance to firms through pre-committed credit lines while at the same time sustaining loan supply to the broader economy, with important implications for monetary policy and financial stability policies.