Liquidity Shocks, Local Banks, and Economic Activity: Evidence from the 2007-2009 Crisis

Abstract

This paper studies the relationship between shocks to local banks and economic activity, by exploiting differences in the liability structure of small U.S. commercial banks during the 2007-09 crisis. Banks that relied more heavily on wholesale liabilities reduced lending relatively more during the crisis than banks funding themselves with retail deposits, suggesting that the use of short-term wholesale funding exposed banks to a sudden dry-up in market liquidity. Moreover, metropolitan areas where banks relied more on wholesale liabilities experienced larger reductions in employment and establishments during the crisis, suggesting that adverse shocks to banks hurt the economy. This effect was stronger in areas with more bank-dependent firms, such as small businesses and firms with higher external financing needs.