Conference Agenda

This paper investigates the relation between bank liquidity and local economic activity. We find that an increase in deposit rates offered by banks within a geographic region is associated with contractions in economic activity. As a region heads to an economic downturn, deposit growth slows down, prompting banks to increase deposit rates to support their balance sheet. This increase in deposit rates reflects the liquidity squeeze experienced by banks due to deteriorating economic conditions, which in turn serves as an indicator of an impending economic contraction.

We document how the interaction of supply chain pressures, heightened household inflation expectations, and firm pricing power contributed to the pandemic-era surge in consumer price inflation in the euro area. Initially, supply chain pressures increased inflation, especially in manufacturing sectors, through a cost-push channel and raised inflation expectations. Subsequently, the cost-push channel intensified as firms with high pricing power increased product markups in sectors witnessing high demand, including in services sectors that were initially not exposed to supply chain constraints. Eventually, even though supply chain pressures eased, these firms were able to further increase markups due to the stickiness of inflation expectations. The resulting persistent impact on inflation suggests supply-side impulses can generalize into broad-based inflation via an interaction of household expectations and firm pricing power.

We introduce a framework to understand and quantify a form of liquidity risk that we dub Liquidity After Solvency Hedging or "LASH" risk. Financial institutions take LASH risk when they hedge against losses, using strategies that lead to liquidity needs when the value of the hedge falls, even as solvency improves. We focus on LASH risk relating to interest rate movements. Our framework implies that institutions with longer duration liabilities than assets - e.g. pension funds and insurers - take more LASH risk as interest rates fall, because solvency concerns rise in a low rate environment. Using UK regulatory data from 2019-22 on the universe of sterling repo and swap transactions, we measure, in real time and at the institution level, LASH risk for the non-bank sector. We find that at peak LASH risk, a 100bps increase in interest rates would have led to liquidity needs close to the cash holdings of the pension fund and insurance sector. Using a cross-sectional identification strategy, we find that low interest rates caused increases in LASH risk. We then find that the pre-crisis LASH risk of non-banks predicts their bond sales during the September 2022 LDI crisis, contributing to the yield spike in the bond market.