During the financial crisis of 2007-2009, the banking industry suffered a huge decline in liquidity on their own balance sheets, decreasing the amount of money they could lend. Did banks’ efforts to absorb the liquidity shock spike a decline in overall credit supply?

Banks were hit hard during the 2007-2009 financial crisis: in a short span, interbank lending markets froze, markets for asset-backed and mortgage-backed securities collapsed, and borrowers utilized previously approved loan commitments.

For lending markets, the cost was high. While banks with stable sources of financing continued to lend, those with greater amounts of less liquid assets on their balance sheet struggled to absorb the shock, adjusting cash holdings and other liquid assets, and cutting back on new loans.

In a study of the crisis, Bentley Finance Professor Marcia Cornett and colleagues Jamie McNutt, Philip Strahan, and Hassan Tehranian found that the efforts of illiquid banks to raise liquidity during the financial crisis led to a decline in overall credit availability, further deepening the crisis. By investigating the variation in holdings of cash and liquid assets, levels of core deposits and equity, and drawdowns of loan commitments among banks, the authors show why some banks chose to build up liquidity faster than others during the crisis, and how this reduced credit within the system.

The paper finds strong evidence that if banks had gone into fall 2008 less exposed to liquidity risk, credit would have fared better. Most of decline in new credit production stemmed from pressure on bank balance sheets in the form of low levels of liquid assets, takedowns on preexisting loan commitments and funding problems from wholesale markets. In the fourth quarter of 2008, new credit production dropped a staggering $500 billion. The study estimates that lower liquidity exposure across the whole banking system prior to the crisis would have lowered that figure by nearly 90 percent, to $87 billion.

The study also takes a deeper look at the results of the Federal Reserve Bank’s liquidity expansion of $1 trillion over a few weeks in fall 2008. When the Fed attempted to stimulate the economy by adding a huge amount of liquidity, banks that had liquidity on their balance sheets going into the crisis lent out the funds injected by the Fed. However, many banks needed the liquidity from the Fed to solidify their own financial position and could not use the funds to increase lending.

The bottom line is that bank liquidity affects bank lending, particularly during times of financial stress. Thus, regulators should monitor and require banks to maintain sufficient liquidity in peaceful times so that banks can better handle their potential liquidity needs in bad times.