Banks’ responses to funding liquidity shocks: Lending adjustment, liquidity hoarding and fire sales

•We examine banks’ responses to negative market funding shocks.•Banks respond by reducing lending, liquidity hoarding, and fire sales.•Banks adjust their wholesale lending rather than retail lending.•A disruption of the repo funding market urges banks to hoard highly liquid assets.•Fire sales are triggered by liquidity constraints rather than by solvency constraints.

The crisis of 2007–2009 has shown that financial market turbulence can lead to huge funding liquidity problems for banks. This paper provides empirical evidence on banks’ responses to market funding shocks, using data of seventeen of the largest Dutch banks over the period January 2004–April 2010. The dynamic interrelations among instruments of bank liquidity management are modelled in a panel Vector Autoregressive (p-VAR) framework. Orthogonalized impulse responses reveal that banks respond to a negative funding liquidity shock in a number of ways. First, banks reduce lending, especially wholesale lending. Second, banks hoard liquidity in the form of liquid bonds and central bank reserves. Third, banks conduct fire sales of securities, especially equity. Fourth, fire sales are triggered by liquidity constraints rather than by solvency constraints. Finally, there is some causality running from fire sales of equity to wholesale lending and liquidity hoarding.