Contingent Credit Under Stress

Over the past two decades, banks have increasingly focused on offering contingent credit in the form of credit lines as a primary means of corporate borrowing. We review the existing body of research regarding the rationales for banks’ provision of liquidity insurance in the form of credit lines, their significance in managing corporate liquidity, and the reasons and circumstances under which firms opt to utilize them. We emphasize that the options for firms to both draw down and repay credit lines are put options issued by banks, which are exercised by firms in a correlated manner during periods of widespread stress, with adverse effects on bank intermediation thereafter. We discuss the bank capital and the bank funding channels that can drive these effects, contrasting their roles during the global financial crisis of 2007–2008 and the COVID-19 outbreak. We conclude by discussing the increasing extension of bank credit lines to nonbank financial intermediaries as well as the role of stress tests and monetary policy in managing the risks of contingent credit under stress.