Managing Bank Liquidity Risk: How Deposit-Loan Synergies Vary with Market Conditions

Liquidity risk in banking has been attributed to transactions deposits and their potential to spark runs or panics. We show instead that transactions deposits help banks hedge liquidity risk from unused loan commitments. Bank stock-return volatility increases with unused commitments, but the increase is smaller for banks with high levels of transactions deposits. This deposit-lending risk management synergy becomes more powerful during periods of tight liquidity, when nervous investors move funds into their banks. Our results reverse the standard notion of liquidity risk at banks, where runs from depositors had been seen as the cause of trouble.