Liquidity Risk and the Credit Crunch of 2007-2009: Evidence from Micro-Level Data on Mortgage Loan Applications

I test the hypothesis that the banks' exposure to liquidity risk contributed to the contraction of mortgage credit during the financial crisis of 2007-2009. I use micro-level data on mortgage loan applications to control for variation in demand conditions and find that lenders who relied less on core-deposit funding or who had larger off-balance sheet exposure to credit lines, exhibited a sharper decline in their propensity to approve loan applications. These two sources of liquidity risk jointly accounted for a $41.5 billion-$61.9 billion contraction of mortgage credit during 2007-2009, or 5.2%-7.8% of total mortgage originations during this period.