Discretion and Systemic Risk in Credit-Line Contracts: Theory and Evidence

We provide evidence that credit lines are a contingent source of liquidity and, therefore, an imperfect substitute for cash holdings. We consider the role of credit line covenants in rationing scarce liquidity. Credit lines serve as insurance against liquidity shocks and provide firms with access to loans at favorable terms in case of a liquidity need. Banks use covenants to ration scarce liquidity during systemic liquidity shocks, whereas when liquidity is abundant they preserve the access to credit following a covenant violation because of reputation concerns. Consistent with the predictions of our model, we find that covenant violations outside the recent crisis did not lead to a higher likelihood of credit line revocations. During the crisis period 2007-2008 the revocation probability for firms violating a covenant was higher by 7.1% relative to non-violating firms. We highlight the importance of the additional government guarantees in times of systemic liquidity shocks. These shocks originate in the corporate sector and spill over to the banking sector, leading banks to cancel credit lines. Government guarantees restore the trust in the banking sector and through the flight-to-safety inflow of deposits bring the valuable liquidity to banks, enabling them to cancel fewer credit lines, as happened in 2009. We argue, therefore, that in times of systemic liquidity shocks the regulator can have an immediate impact on the real economy by attracting liquidity to the banking system.