Deposit Volatility, Liquidity and Long-Term Investment: Evidence from a Natural Experiment in Pakistan

Deposit volatility and costly bank liquidity increase the long-term lending rates offered by banks, which reduce loan maturities, long-term investment and output. We formalise this mechanism in a banking model and analyse exogenous variation in deposit volatility induced by a Sharia levy in Pakistan. Data from the credit registry and a firm-level survey show that deposit volatility and liquidity cost: 1) reduce loan maturities and lending rates; 2) leave loan amounts and total investment unchanged; 3) redirect investment from fixed assets towards working capital. A targeted liquidity program is quantified to generate yearly output gains between 0.042% and 0.205%.