Tracing the Impact of Bank Liquidity Shocks

While bank lending may fall in response to shocks to their liquidity, to what extent are such shocks transmitted to borrowing …rms? Tracing such transmission mechanisms has proven di¢ cult in the past due to a lack of micro data linking banks to borrowing …rms and identi…cation concerns. This paper uses di¤erential liquidity shocks arising from unanticipated nuclear tests in Pakistan in 1998, and a dataset linking over 18; 000 …rms to all 145 banks to understand the full transmission mechanism. We isolate the causal impact of the bank lending channel by showing that for the same …rm borrowing from two di¤erent banks, its loan from the bank experiencing a 1% larger decline in liquidity drops by an additional 0.6%. The liquidity shock also leads to large declines in the probability of continued lending to old clients, and extending credit to new ones. However, we …nd that …rms di¤er in their ability to compensate the bank lending channel shock. Larger …rms, while also facing a bank lending channel, are able to o¤set the adverse e¤ect by borrowing more from more liquid banks. Smaller …rms on the other hand are entiely unable to hedge out the bank lending channels. Consequently, a negative bank liquidity shock increases the probability of …nancial distress for smaller …rms, while no such e¤ect exists for large …rms. Therefore while bank liquidity shocks may not have a notable impact on overall lending as large borowers are able to compensate these shocks, they have substantial distributional consequences due to a large adverse and persistent impact on smaller …rms.