https://macropaperwarehouse.com/authors/jose-e.-gutierrez/José E. GutiérrezHugo -- gohugo.ioen-ushttps://macropaperwarehouse.com/papers/regulating-credit-lines-in-the-presence-of-fire-sale-externalities/https://macropaperwarehouse.com/papers/regulating-credit-lines-in-the-presence-of-fire-sale-externalities/<p>This paper provides a contract-theoretic rationale for the special liquidity regulation of bank credit lines—a form of lending that has received little attention in the regulatory literature despite being the most important source of firm liquidity risk management. In the model, banks choose pre-arranged funding (committed before drawdowns accumulate) and ex-post funding (raised as drawdowns occur) to finance firms&rsquo; liquidity needs through credit lines. In states with high liquidity needs, banks cannot raise sufficient ex-post funding to meet all drawdowns and renege on some credit lines, forcing liquidations. Because each additional liquidation depresses the equilibrium liquidation value for all liquidated firms—a pecuniary externality—competitive banks choose insufficient pre-arranged funding in the private equilibrium. A minimum requirement on bank pre-arranged funding per committed (undrawn) funds in credit lines restores constrained efficiency, despite making credit lines more costly; welfare improves because more firms receive funding in high-liquidity states. The optimal regulatory ratio is increasing in the frequency of high-liquidity-need states, the value lost in liquidation, and the sensitivity of liquidation values to forced sales, and decreasing in the premium on pre-arranged funding.</p>