Aggregate Risk and the Choice between Cash and Lines of Credit*

We argue that a firm’s aggregate risk is a key determinant of whether it manages its future liquidity needs through cash reserves or bank lines of credit. Banks create liquidity for firms by pooling their idiosyncratic risks. As a result, firms with high aggregate risk find it costly to get credit lines from banks, and opt for cash reserves in spite of higher opportunity costs and liquidity premium. We verify this hypothesis empirically by showing that firms with high asset beta have a higher ratio of cash reserves to lines of credit, controlling for other determinants of liquidity policy. The effect of aggregate risk on liquidity management is economically significant, and is robust to variation in the proxies for firms’ exposure to aggregate risk, and availability of credit lines. This effect is true at the firm level as well as the industry level, and it is significantly stronger in times when aggregate risk is higher. The positive relation between a preference for cash and asset risk is particularly strong for firms that are more likely to be financially constrained (small, non-rated, low payout firms).