Aggregate liquidity and banking: The role of loan commitments and liquidity constraints

Access to short-term credit is an important source of liquidity for firms. This article shows that the usual asymmetric information problem in credit markets can result in an oversupply of trade credits, eventually leading to over-production of liquidity and underinvestment in long-term projects. Banks help to solve this problem. They arrange a fixed credit line (or loan commitment) with a firm which constrains its borrowings even if it runs into difficulties. Hence, in the aggregate, banks reduce liquidity for the benefit of an increase in long-term investments. This model thus offers another view on the liquidity transformation function of banks.