Wholesale Funding Dry‐Ups

• Author: DAVID THESMAR,CHRISTOPHE PÉRIGNON,GUILLAUME VUILLEMEY
• Published date: 01 April 2018
• DOI: http://doi.org/10.1111/jofi.12592
• Date: 01 April 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 2 •APRIL 2018

Wholesale Funding Dry-Ups

CHRISTOPHE P ´

ERIGNON, DAVID THESMAR, and GUILLAUME VUILLEMEY∗

ABSTRACT

We empirically explore the fragility of wholesale funding of banks, using transaction-

level data on short-term, unsecured certificates of deposit in the European market.

We do not observe a market-wide freeze during the 2008 to 2014 period. Yet, many

banks suddenly experience funding dry-ups. Dry-ups predict, but do not cause, future

deterioration in bank performance. Furthermore, during periods of market stress,

banks with high future performance tend to increase reliance on wholesale funding.

We therefore fail to find evidence consistent with adverse selection models of fund-

ing market freezes. Our evidence is in line with theories highlighting heterogeneity

between informed and uninformed lenders.

TO FINANCE THEMSELVES,BANKS RELY ON deposits and wholesale funding. The

latter includes repurchase agreements, interbank loans, and debt securities

sold on financial markets, often with short-term maturities. A prevailing view

among economists and regulators is that wholesale funding is vulnerable to

sudden stops, or dry-ups, during which banks lose funding regardless of their

credit quality. Such breakdowns have major macroeconomic consequences, as

they may force banks to cut lending (Iyer et al. (2014)) and affect real out-

comes such as unemployment (Chodorow-Reich (2014)). To mitigate this con-

cern, new regulatory liquidity ratios penalize the use of wholesale funding

(Tarullo (2014)).

In this paper, we empirically investigate the determinants of the fragility of

wholesale funding markets. Most theories of market freezes are based on in-

formation asymmetries between lenders and borrowers. Among these theories,

two classes of models make opposite predictions about the causes of whole-

sale funding market breakdowns. The first class of theories assumes that all

∗Christophe P´

erignon is at HEC Paris. David Thesmar is at MIT Sloan and CEPR. Guillaume

Vuillemeyis at HEC Paris and CEPR. We are grateful to Laurent Clerc and to Service des Titres de

Cr´

eances N´

egociables at the Banque de France for providing data on certificates of deposit. Simone

Manganelli and Angelo Ranaldo graciously shared their interbank loan and repo data. Comments

and suggestions from Charles Calomiris, Laurent Clerc, Paolo Colla, Jean-Edouard Colliard, Adam

Copeland, Matteo Crosignani, Darrell Duffie, Co-Pierre Georg, Itay Goldstein, Gary Gorton, Denis

Gromb, Florian Heider, Bengt Holmstr¨

om, Rajkamal Iyer, Benjamin Munyan, Enrique Schroth,

Javier Suarez, Anjan Thakor, as well as from participants at numerous seminars and confer-

ences, are gratefully acknowledged. We thank the Chair ACPR/Risk Foundation: Regulation and

Systemic Risk, the French National Research Agency (F-STAR ANR-17-CE26-0007-01), and the

Investissements d’Avenir (ANR-11-IDEX-0003/Labex Ecodec/ANR-11-LABX-0047) for supporting

our research. All of the authors have read the Journal of Finance’s disclosure policy and have no

conflicts of interest to disclose.

DOI: 10.1111/jofi.12592

575

576 The Journal of Finance R

lenders are equally uninformed. When lenders become concerned about the

quality of borrowing banks, interest rates increase for both high- and low-

quality banks. This induces high-quality banks to self-select out of the market

(Akerlof (1970), Stiglitz and Weiss (1981), Myers and Majluf (1984)). Therefore,

when investors are uninformed but homogeneous, funding dry-ups are driven

by demand: high-quality banks stop borrowing from the market.

A second strand of theories rests on the idea that some lenders are informed.

In times of stress, uninformed participants expect informed lenders to cut

funding to low-quality banks, and may then prefer to stop lending altogether

(Gorton and Pennacchi (1990), Calomiris and Kahn (1991), Dang, Gorton, and

Holmstr¨

om (2012)). In these models, funding dry-ups are driven by supply:

they predominantly affect low-quality banks, which lose funding from both

informed and uninformed investors. High-quality banks may lose funding from

uninformed investors, but manage to keep funding from informed ones.

Since the two theories make opposite predictions about the quality of banks

experiencing dry-ups, distinguishing between them is useful to understand the

main frictions at work in wholesale funding markets. Distinguishing between

the two theories can also have important policy implications, although such

implications are beyond the scope of the current paper to explore in detail.

While standard adverse selection models suggest that disclosure about issuer

quality is beneficial, proponents of theories based on the presence of some

informed investors emphasize potential benefits of opacity in financial markets

(Holmstr¨

om (2015), Dang et al. (2017)). The idea behind this policy prescription

is that liquidity is enhanced when ignorance about fundamentals is mutually

shared, as information disclosure may reduce risk-sharing opportunities and

eventually lead to market breakdowns.

We test the competing predictions of these two theories using novel data on

a large yet neglected segment of the European wholesale funding market—the

market for certificates of deposit (CDs). CDs are unsecured short-term debt

securities issued by banks and bought mostly by money market funds.1Our

sample consists of more than 80% of the market for euro-denominated CDs. It

covers a large segment of the wholesale funding market, with the amount of

debt outstanding around EUR 400 Bn, which is comparable to the repo market

and about 10 times as large as the unsecured interbank market. Our data

include characteristics of 1.4 million issues by 276 banks from 2008 to 2014.

We match these issuance data with issuer characteristics from Bankscope and

market data from Bloomberg.

Using these data, we identify a number of wholesale funding dry-ups,which

we define as instances in which a given bank’s CDs outstanding falls to zero

(full dry-up) or drops by more than 50% over the course of 50 days (partial

dry-up). We isolate 75 such events between 2008 and 2014, of which 29 are full

dry-ups. Based on observable characteristics, banks that experience dry-ups

have on average lower profitability,more impaired loans, higher book leverage,

1Bank CDs are the counterpart to commercial paper issued by nonfinancial corporations (Kahl,

Shivdasani, and Wang (2015)).

Wholesale Funding Dry-Ups 577

and a lower creditworthiness than other banks. This is in line with evidence

from the market for asset-backed commercial paper (Covitz, Liang, and Suarez

(2013)). Importantly, the CD market did not experience any global freeze and

dry-ups did not have a strong aggregate component. This is quite remarkable,

given that CDs are unsecured and our sample period includes both the financial

crisis and the European sovereign debt crisis.

We next show that banks experiencing dry-ups are those whose performance

is set to decrease in the future, controlling for current performance. This re-

sult casts doubt on the idea that high-quality banks self-select out of the CD

market due to asymmetric information in their relation with lenders. It is in-

stead consistent with the idea that low-quality banks lose funding from both

informed and uninformed lenders. Using stock prices, we find that dry-ups are

preceded by negative abnormal returns, which is consistent with negative pub-

lic information being revealed and leading uninformed investors to withdraw

funding.

We reject an alternative interpretation of our findings that follows theories

of runs as in Diamond and Dybvig (1983) or Goldstein and Pauzner (2005). In

theory, funding dry-ups could be purely uninformed events that cause lower

future performance, for instance, because the lack of funding forces banks to

liquidate assets at fire-sale prices or to pass on valuable lending opportunities.

In this case, runs can be self-fulfilling equilibria where banks lose funding

even when their fundamental value is high. We address this reverse causality

concern by running several tests. First, a sharp reduction in CD funding also

predicts a future increase in impaired loans, a measure that is less prone

to reverse causality, as loans were extended prior to the dry-up. Second, the

predictive power of dry-ups on performance is not driven by banks that rely

heavily on CD funding—to which a drop in CD funding may cause more harm.

Third, the total assets of banks facing dry-ups remain stable in the following

year, suggesting that dry-ups do not force banks to engage in fire sales.

Aside from the predictive power of dry-ups, we provide three additional

results consistent with theories based on heterogeneously informed lenders.

First, we show that issuers facing a dry-up experience a decrease in the ma-

turity of new CD issues several months before the decline in CD volume. In

the presence of informed investors, uninformed lenders value debt securities

as long as they remain information-insensitive (Gorton and Pennacchi (1990)).

In times of stress, long-term debt becomes more information-sensitive, since it

is repaid later. Uninformed investors can then refuse to buy longer term CDs

(Holmstr¨

om (2015)). Therefore, the only way to draw uninformed funding in

times of stress is by reducing maturity. This mechanism explains the pattern

found in the data. Second, we show that issuers facing a dry-up almost never

reenter the market. This is consistent with the fact that these issuers are no

longer perceived as safe. If, instead, adverse selection were at play,high-quality

banks would be expected to re-enter the market after they have been identified

as such. Third, the shift from information-insensitive to information-sensitive

debt should follow the arrival of public news causing uninformed lenders to re-

vise their beliefs (Dang, Gorton, and Holmstr¨

om (2012)). We show that ratings