Tracing the Impact of Bank Liquidity Shocks: Evidence from an Emerging Market

TLDR

The study examines how unanticipated nuclear tests in Pakistan create cross‑bank liquidity variation and uses this shock to assess its impact on firm borrowing. Liquidity shocks reduce firm borrowing: a 1% larger liquidity decline at a bank lowers that bank’s loan by 0.6%, and while large firms offset the loss through additional credit, small firms experience significant borrowing cuts and heightened financial distress. JEL classification: E44, G21, G32, L25.

Abstract

We examine the impact of liquidity shocks by exploiting cross-bank liquidity variation induced by unanticipated nuclear tests in Pakistan. We show that for the same firm borrowing from two different banks, its loan from the bank experiencing a 1 percent larger decline in liquidity drops by an additional 0.6 percent. While banks pass their liquidity shocks on to firms, large firms—particularly those with strong business or political ties—completely compensate this loss by additional borrowing through the credit market. Small firms are unable to do so and face large drops in overall borrowing and increased financial distress. (JEL E44, G21, G32, L25)