Emergency Liquidity : Impact on Default Likelihood of Corporate Credits

We analyzed default likelihood of North-American corporate obligors in 1995-2014 using Moody's DRD quarterly data for both public and private borrowers. Emergency actions by the lender of last resort (LOLR) during 2008-2009 were a novelty so the impact on credit quality of bank portfolios and their loss provisions is not clear at all. To study the impact of emergency liquidity and lending we introduce an instrumental variable, responsible for available emergency liquidity, into the model. The study shows that the presence of emergency lending provisions produces significant impact on default probabilities by reducing the impact of macroeconomic conditions. This means that calibration of capital testing models should account for emergency liquidity (ELA) presence. We showed that given the limited amount of relevant historical data, ignoring ELA in historical fit causes an underestimation of default probability under stress and, apparently, underestimates stress capital requirements