The role of interbank lending market liquidity in corporate cash holdings

Abstract

PURPOSE OF THE STUDY

This thesis examines the role of interbank lending market liquidity in the cash holdings of companies incorporated in Europe. The study builds on the trade-off theory of cash holdings which suggests that there exists an optimal level of cash that should be actively pursued by the management. The first objective of the study is to analyze whether companies have larger precautionary cash reserves when the liquidity in the interbank lending market, measured with a spread between London interbank offered rate and overnight index swap rate (Libor-OIS), is low. I also test whether the relation is stronger during the financial crisis of 2007-2009. The second objective is to analyze whether company specific characteristics, such as the level of financial constraints or cash flow riskiness, affect the hypothesized negative relation. The thesis contributes to the existing literature on the determinants of cash holdings by establishing a link between the corporate cash policy and the interbank market liquidity using the Libor-OIS spread.

DATA

The data set consists of quarterly financials from 2,227 public non-financial companies incorporated in 30 European countries. The sample period spans from the first quarter of 2000 to the end of 2011. The final sample comprises 16,701 firm fiscal quarters. The company financials are extracted from Thomson ONE Banker Reuters data base. The daily interest rate data for the liquidity proxy, Libor-OIS, is retrieved from Thomson Datastream and merged with the accounting data by taking an average from a period matched with a company’s fiscal period at issue.

RESULTS

My findings support the hypothesis that companies hold larger cash reserves when the liquidity in the interbank lending market is low. If the credit spread widens by one standard deviation, the baseline regression model suggests that during the following quarter an average company increases its cash ratio by 0.54 ppt. or cash holdings by €0.8 million. The recorded negative relation seems to be both statistically and economically stronger for the crisis period of 2007-2009 and the corresponding increase in the cash ratio is 0.9 ppt. or €1.2 million in the cash level. The sign of the relation stays intact when I test the hypotheses by using percentage changes in the regression variables, but due to a large noise in the liquidity proxy the result lacks statistical significance. In the analyses on the company specific characteristics, four out of five definitions for financial constraints suggest that the negative relation is significant only for financially constrained companies. Contrary to expectations, interbank liquidity is not a significant determinant of the cash ratio for companies with risky cash flows. Finally, I find statistically weak evidence that the negative relation would be stronger for recently listed companies.