Date – 13th November, 2020

Student number - 202085409

Class (inc class code) – BF992: Research Methods

Title of assignment – Critical Review

Tutor name (s) – Mr. Daniel Broby

Abstract (150 words maximum) – The purpose of Tthis paper is to provides a critical
review of any relevant article within the research scope. The chosen article was namely
“Banks as Lenders of First Resort: Evidence from the COVID-19 Crisis”. The article
highlighted –backed by empirical evidence – the significant unprecedented increase in
demand for liquidity in the US market by business firms and an assessment of the
consequences that this demand had on US banks’ liquidity relevant to its size. This is an
important question because ……. The latter was addressed in the context of the COVID-19
Crisis and how this event had affected US Banks’ liquidity specifically and their balance
sheet position in general. The contribution of the paper was…….
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Introduction

The key research question of the paper under review was…… The main rationale of
selecting the mentioned article to review was the important relevance between the article’s
subject and the area that is been targeted for my DBA research, especially related to the
impact of Covid-19 crisis on the financial sector. Here the article focuses specifically on the
lending capabilities of Banks in the US before and at the start of the crisis and whether its
liquidity was adversely impacted and consequently affected its lending capabilities to firms
through commercial and industrial loans. The article authors focused on the analysis from the
Banks’ point of view rather than the business firms seeking these loans due to their
emergency liquidity needs as a result of the financial crisis. What influenced the decision to
pick the article was the detailed analysis it provides and the link it has with the current market
conditions.

The main contribution the article provides is contributing to the literature on Banks’ role as
liquidity suppliers to firms with the conclusion that…..

Review

At the start of its analysis, the article highlighted the weekly growth in commercial and
industrial loans (C&I) on Banks’ balance sheets from the period January 1973 until April
2020. Indeed, the data reflected a significant spike in Banks’ C&I lending in April 2020 that
supports the author’s point of view on the contrast between lending activity for Banks before
and at the start of the crisis. The data confirms that Banks’ C&I lending was 2% on average
for the last 47 years, whereas this percentage spiked to 8% as a result of the crisis. However,
on the other hand the analysis had the limitation that , the data was not seasonally adjusted to
reflect possible impact of timing on lending activity. In addition, it is observed that no direct
queries have taken place with Bank personnel to comment on the relevance of the data or
whether other factors might have possibly affected the skewness of the posted data. I believe
such analysis would have added to the richness of the analysis.
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The article builds on a number of academics including……

The next attempt by the article was to narrow down the analysis further. The article tried to
prove that loan drawdowns came mainly from large firms who typically borrow from the
largest Banks, specifically for Banks with assets over $50 billion than for other banks. Here
again the data supported the author’s point of view in that the main significant growth in C&I
loans during March-April 2020 came from Banks’ with have assets more than $50 billion
compared to smaller Banks that also had growth in C&I loans but not as significant as the
larger Banks, which provides evidence that US firms – especially the large ones – rely
heavily on their credit lines with large Banks to meet their massive increase in liquidity
requirements as a result of the pandemic and resulting financial crisis. However, in my
opinion the data was calculated mainly by the author himself using one of the Federal
Reserve Bank financial data releases for all U.S. commercial Banks, without being sourced
from the Banks’ directly or their audited financials. Furthermore, the data analysis could have
been more relevant if direct information through interviews or meetings had been sought
from the Banks’ and the firms using C&I loans from Banks to corroborate the data.

The paper focuses on two specific questions:

First, how has firm demand for Bank liquidity responded to the onset of the Covid-19
crisis?

Although it is very challenging to identify whether the choice of city or state might have
affected the results due to the varied level of outbreaks in different locations within
the U.S., the article tried to mitigate the latter factor by assessing the level of local
employment declines in small firms and by checking ex post death rates from the
COVID-19. The article then concluded that much larger increases at Banks located
near large outbreaks relative to areas with a lower level of virus outbreak.

Second, does Bank pre-shock financial condition constrain their ability to meet the
unexpected increase in liquidity demand from their business clientele?

To tackle the above question, the article used a more systematic approach by relying on
previous models developed by relevant research firms that were conducted post the
2008 financial crisis in an attempt to draw useful conclusions related to the current
financial crisis and how this might have affected Banks’ credit supply. They have
drawn the conclusion that Banks more reliant on core deposits, Banks holding more
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liquid assets and Banks with more capital have actually increased lending activity
compared to other Banks.

However, the article was not able to prove that lending grew more at Banks financed more
with stable deposits before the crisis. At the same time, it was not able to establish that pre-
crisis measures of asset liquidity explained increases in lending. The article suggests – based
on the latter non-evidence – that concern about liquidity posed no constraint on Banks, in
strong contrast to what happened during the 2008 crisis. The author’s attempt to highlight the
2008 financial crisis within the paper was quite important and reasonable given that the past
event was the closest in terms of financial impact on Banks and the economy overall.
However, the article could not establish strong resemblance between the two events.

The article also sets clearly the source of the data that has been used to perform the analysis
and at the same time supports the selection by using a different set of reported data. This
approach adds more reliability towards the data used and the conclusions drawn from such
data. However, the paper lacks clear reliance on qualitative aspects such as visiting local
firms or Banks, spending a significant amount of time with the actual market players to better
understand the data and ensure relevance of the information. Furthermore, to investigate
whether other factors might have impacted the relevance of the data or beyond what the data
may suggest such as Government interference, FED’s market activity, specific firms’ demand
for liquidity, Banks’ profitability and cash flow situation etc.

The article claims to contribute to the emerging literature on the economic and financial
consequences of the COVID-19 crisis. It also provides some references with other similar
articles that cover market impact analysis due to the crisis which adds to its relevance and
highlights certain areas of similarities. However, I believe the article narrowly defines the
impact of the COVID-19 crisis through a limited set of factors strictly the impact on
commercial and industrial lending as a sole indication of potential liquidity constraints on
Banks without building a holistic view on the banking industry, overall economy and other
areas within the financial markets that have been significantly impacted but intentionally
omitted from the scope of this article. Furthermore, other relevant factors such as capital
ratios, Banks’ tactical and strategic initiatives, and business objectives that could have
significant implications on the Banks’ performance and liquidity and profitability targets.
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On the other hand, the article provides no evidence that capital constrained Banks’ ability to
meet significant unprecedented demand for cash. However, it only supported its point of view
on the basis of individual Bank lending behaviour only which could be somewhat misleading
and inconclusive.

The article then highlights another important challenge the Banks have faced. How were
Banks able to pass the unprecedented liquidity stress test from COVID-19? The author
concludes that policy makers appear to have learned the importance of swift response from
the 2008 crisis, when market interventions occurred much more slowly, incrementally, and
only as a reaction to market events. At the same time, the author believes that Banks have
received large inflows of deposits simultaneous to the time that firms demanded liquidity
from the Banks. Finally, regulatory changes that enhanced Banks’ capital due to Basel
requirements have directly helped Banks’ stress tolerance. What I find somewhat
contradictory is that the article on one hand established that the level of the Banks’ capital
had no direct influence on the magnitude of their C&I lending. On the other hand, the article
re-establishes the importance of adequate capital levels post the 2008 crisis that enabled
Banks to have ample and healthy liquidity levels in order to support the significant demand
for C&I loans required by many firms during the current COVID-19 crisis.

In contrast, the article has also highlighted one of the downsides of excessive C&I lending by
Banks especially the large Banks with assets over US$ 50 billion, as the increase in lending
will be associated by an increase in the risk-weighted assets, thereby moving them closer to
regulatory minimum capital ratios. Moreover, the spike in loans will be associated with more
loan provisioning and accordingly reduce capital ratios further. A further point that caused a
differing view on their main conclusion – that the level of capital did not have a significant
impact on the Banks’ ability to provide new loans – is the article’s anticipation that capital
may in fact hinder future loan growth unless Banks take steps to lower capital distributions
and / or raise new equity which again causes some confusion and poses a contradictory point
of view with reference to their main conclusion on Banks’ ability on providing uninterrupted
C&I loan lending during the COVID-19 crisis.

The article then provides empirical evidence comparing all Banks’ ratios in terms of asset
size, unused C&I commitments, weekly change in C&I loans/assets, liquid assets/assets, core
deposits/assets, Tier 1 capital/assets while at the same time providing comparisons in the
number of hours worked across different-sized Banks. The article attempts to prove that there
has been a dramatic shift (increase) in Bank lending that occurs during the crisis week.
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However, the compared percentages appear too small to prove the article’s point of view.
Nonetheless, the author rationalises the above fact due to normalization the changes by the
size of each Bank. Furthermore, the article draws a link between significant increases in
lending – during the crisis – with a significant drop in employment data across different sized
firms. However, this is more evident in small firms compared to the larger ones. Again, the
article shows that the largest Banks witnessed the greatest increase in liquidity demand.
Although the article uses the data to reflect that lending grew much faster during the crisis
weeks, with the most increase noticed at the largest Banks, the article did not adequately or
qualitatively explain why this increase was witnessed mainly by large Banks compared to the
mid-sized or small Banks. Even though the ratios support their point of view but not enough
clarification was given to better understand – away from the empirical data – the reasoning
behind this figures.

Other measures that have been used such as liquid assets, core deposits, and Tier 1 capital
proved to be either not statistically significant or economically small. Although, the article
attempted to include other variables to establish additional links between liquidity levels /
demand for loans during the crisis, the insignificance of the results has not helped the article
establish any further significant relationships.

The article then highlights further shortfalls in the results because of inability to segregate
new loan originations from drawdowns on pre-existing loan commitments because of the way
the change in loans on Bank balance sheets is calculated which equals the sum of net
drawdowns on existing credit lines plus new originations. The article debated that the
variation they observed in the data reflects drawdowns – not originations – however, they
were not able to directly demonstrate that claim. Even the sample they used as a source of
Banks’ data does not include all Banks. Hence, such clear discrepancies do not allow the
reader to draw clear conclusions on the presented information. Although, the article tried to
overcome such shortfall by using an additional source of data, specifically Call Report Data.

A further point that might have affected the results is the location-specific measures of
demand. The article has left out location-specific measures of demand because these are not
well-defined during the pre-crisis quarters as per their analysis.

Another comparison provided by the article was looking at all Banks first then at Banks in
each of three size categories. The main point that is worth mentioning that on-balance sheet
lending did not show any difference between Q1 2020 (at the start of the crisis) and the
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earlier quarters, which again affects the strength of the point that the article is trying to make
about pre and post-crisis lending levels relative to the size of the Banks.

Further data analysis depicted by the article and uses all Banks – rather than a subset – uses a
different pre-crisis benchmark (all of 2018 and 2019, rather than the first weeks of Q1 2020),
and has no cross-state control for the level of the viral outbreak. In particular, the article tries
to corroborate evidence that the growth in lending in Q1 2020 is best explained by the level
of pre-existing business loan commitments. Again, the article tries to narrowly define the
changes and mainly linked to large Banks which affects the outcome and the overall
contribution of the article.

Despite the article’s conclusion that the Banks have successfully accommodated the
unprecedented increase in liquidity demands in response to the ongoing COVID-19
pandemic, relying mainly on the parameter of pre-existing unused loan commitments to
explain the majority of the variation in lending especially for large Banks, the article was not
able to prove any correlation between Bank financial strength and their willingness to bear
this liquidity shock. From my perspective, it’s again contradictory, that there is no correlation
between Banks’ financial strength and their willingness to bear liquidity shock and hence
provide increased loans as per the main point that the article is trying to prove. However, the
article defends this contradiction by highlighting the possible changes in the regulatory
regime after the 2008 crisis, the Federal’s aggressive actions in response to the pandemic, and
a large increase in Bank deposits as justifiable reasons for their results.

The article further explains that increases in Banks’ liquidity became almost as a natural side
effect of the massive expansion of the Federal Reserve’s balance sheet from QE, as it
effectively expands the supply of excess reserves. I do agree with this specific point of view
given the ample excess liquidity that became available to US Banks since the beginning of
the COVID-19 crisis, since as the article confirmed, the rapid expansion of the Federal
Reserve balance sheet has led to about $900 billion in additional cash (i.e. reserves) in the
banking system. This result was proven by collected data that reflected the amount of cash in
the banking system is almost double the increase in C&I loans. The other point that supports
the increase in cash in the banking system as addressed by the article, is the shift in policy by
the FED that resulted in moving expanded liquidity supply from the central bank to
commercial Banks just as nonfinancial firms were drawing liquidity from their Banks.
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I believe the above conclusion strongly supports the article’s main point of view that the
increase in C&I loan supply was not really sensitive to capital levels and spiked mainly based
on increased demand by US firms, especially from largest US Banks. It also overshadows any
other parameters that have shown contradiction to the main point of view or other non-
aligned results that were discovered during the data analysis.

Conclusion

In conclusion I believe the article is (is not) a scholarly contribution to the literature on
liquidity and banking. The article has statistically and through empirical study analysed the
largest liquidity shock to the banking system ever observed. It also proved that liquidity
demands on Banks reached unprecedented levels during March / April 2020 at the start of the
COVID-19 crisis. Equally, the article tried to prove that firms went to their Banks for cash,
drawing funds from pre-existing credit lines and loan commitments to face any financial
disruptions and also in anticipation of massive declines in future cash flows. It also concluded
that large Banks experienced the lion’s share of these liquidity demands. Finally, it has also
successfully proven that Bank liquidity and Bank capital buffers were both substantially more
resilient before the COVID-19 crisis than they were before the 2008 crisis. Moreover, from a
timing perspective, the article believes that the aggregate liquidity supply, from both the
Federal Reserve and depositors, flowed in exactly the right time to avoid a more massive
financial crisis.

However, the article would have been more successful, if it had introduced qualitative
research aspects to its analysis such as interviews with firms and Bank employees and direct
surveys with relevant market players including the Federal Reserve. At the same time,
expanding the scope of the analysis beyond the increase in C&I loan supply, to include other
important dimensions within Banks’ balance sheets, would have provided a broader and
cross-dimensional point of view on the Banking and overall financial industry.

Reference:

Banks as Lenders of First Resort: Evidence from the COVID-19 Crisis

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Lei Li, Philip E Strahan, Song Zhang

The Review of Corporate Finance Studies, Volume 9, Issue 3, November 2020, Pages 472-
500

https://doi.org/10.1093/rcfs/cfaa009