Asymmetric effects of the business cycle on bank funding liquidity

This study uses a panel smooth transition regression (PSTR) framework and a novel measure of business cycle (BC) to document regime-dependent, non-linear dynamics in funding liquidity, a relationship that existing linear studies have not captured but that is beneficial for countercyclical macroprudential policy calibration. Employing PSTR framework on quarterly data of U.S. bank holding companies from 1990Q1 to 2021Q4 and the business cycle index of Brave et al. (2019), we document strong evidence of nonlinear dynamics in the relationship between BC conditions and funding liquidity risk. Specifically, the BC exerts a negative and statistically significant effect on funding liquidity risk, indicating that banks tend to build capital buffers and adopt more conservative funding strategies during economic downturns, while expanding lending activity during economic upswings. In contrast, financial crisis episodes are associated with a positive effect on funding liquidity, consistent with the flight-to-safety (or flight-to-capital) hypothesis, whereby depositors reallocate funds toward relatively safer bank deposits during periods of higher uncertainty. These findings underscore the role of BC index's thresholds in liquidity dynamics and suggest that policymakers and bank supervisors incorporate nonlinear macro-financial effects when designing countercyclical liquidity and bailout measures to ease banks' funding constraints during stress periods. The study has important implications for bank managers in terms of adjusting funding liquidity buffers and risk-taking across BC regimes.