Matthew Plosner, an economist with the New York Federal Reserve, asks why banks keep unexpected deposit money instead of paying down debt or lending it.

For banks in energy-producing areas, there are three major uses of the deposit windfall: they can make more loans, invest in liquid assets, and pay down debt. If loan demand falls, all else being equal, other uses of funds should increase. Therefore, I should see both increased allocations to liquid assets and increased paydown of debt. In the pre-recessionary period, 2003-07, 9 percent of the deposit inflow is allocated to debt paydown. However, when loan allocations fell during the recession, banksreduced debt paydown and increased liquid asset allocations. The pattern of activity is not consistent with the falling loan demand narrative.

Finally, if the cause is a shortage of demand for loans, larger banks with a wider footprint should be better able to find uses for funds. A test to see if banks operating in more counties exhibit a stronger lending propensity during this period does not detect a meaningful difference; banks with more than one branch lend slightly more, but the difference is small and not statistically significant.

The development of unconventional energy provides a unique laboratory to observe how banks allocate unsolicited deposits. The ability of affected banks to allocate deposits toward loans varied significantly over the business cycle. While loan demand may have declined in the crisis, it does not easily explain why banks reduced both debt paydown and lending in order to hold cash and securities. When I compare different types of banks, I observe banks that lack access to non-deposit financing and banks with less tolerance for risk are more sensitive to the business cycle, consistent with a heightened demand for precautionary liquidity. The results highlight heterogeneity in banks’ response to the business cycle that can impede capital reallocation during downturns.