Liquidity Risk and Limited Arbitrage: Why Banks Lend to Opaque Hedge Funds

Hedge funds attempting to take advantage of market-wide liquidity shocks are not limited by opaqueness-caused capital constraints, because banks optimally supply them with backup credit lines. During such shocks, government-protected bank deposits receive inflows that lower a bank’s opportunity cost of lending. The inflows also provide a private signal that helps the bank estimate the timing and magnitude of a shock, thus reducing the information asymmetry constraining hedge funds. The unique combination of exclusive low funding cost and sophisticated information gives banks an advantage in lending to hedge funds. ∗Boston College, Chestnut Hill, MA 02467. I am grateful to Pierluigi Balduzzi, Lily Fang, Wayne Ferson, Edie Hotchkiss, Ning Gong, Ed Kane, Alan Marcus, Jeff Pontiff, Matt Spiegel, Phil Strahan, Marti Subrahmanayan, seminar participants at Boston College, INSEAD, University of Amsterdam and CICF 2007 meeting participants for helpful discussions and suggestions.