Banks' Liquidity Management During the COVID-19 Pandemic

Abstract

How banks managed the COVID-19 pandemic shock? The eruption of the financial crisis in 2007 evolved to a crisis of banks as liquidity providers (Acharya and Mora, 2015). The COVID-19 pandemic shock was associated with a surge in households’ deposits and a subsequent liquidity injection by the Federal Reserve. We show how the pandemic affected banks’ liquidity management and therefore by extension, the creation of new loans. We empirically evaluate the creation and management of banks’ liquidity through three well established mechanisms: market discipline (supply-side), internal capital markets (demand-side), and the balance-sheet mechanism which captures banks’ exposure to liquidity demand risk. We provide novel empirical evidence showing that households increased savings as a precaution against future declines in their income. Also, depositors did not discipline riskier banks, and the internal capital market mechanism was not in work during the pandemic. Hence, weakly-capitalized banks were not forced to offer higher deposit rates to stem deposit outflows. Furthermore, weakly-capitalized banks increased lending in the first phase of the pandemic, while in the midst of the pandemic, they cut back new lending origination and increased their exposure to Fed’s liquidity facilities. Well-capitalized banks on the other hand, increased lending in line with the increase in their deposits. Banks with higher exposure to liquidity risk were vulnerable to deposit outflows and increased their exposure in Fed’s liquidity facilities significantly more than low-commitments exposed banks.