Bank Solvency and Funding Cost

Abstract

Understanding the interaction between bank solvency and funding cost is a crucial prerequisite for stress-testing. In this paper we study the sensitivity of bank funding cost to solvency measures while controlling for various other measures of bank fundamentals. The analysis includes two measures of bank funding cost: (a) average funding cost and (b) interbank funding cost as a proxy of wholesale funding cost. The main findings are: (1) Solvency is negatively and significantly related to measures of funding cost, but the effect is small in magnitude. (2) On average, the relationship is stronger for interbank funding cost than for average funding cost. (3) During periods of stress interbank funding cost is more sensitive to solvency than in normal times. Finally, (4) the relationship between funding cost and solvency appears to be non-linear, with higher sensitivity of funding cost at lower levels of solvency.

The interaction between bank solvency and funding costs: A crucial effect in stress tests

“…All listed papers—except Babihuga and Spaltro () —use multivariate panel estimation models in their funding cost equations. Aymanns, Caceres, Daniel, and Schumacher (); Babihuga and Spaltro () and Gambacorta and Shin () use capital ratios as their solvency coefficient while Annaert, De Ceuster, Van Roy, and Vespro () and Hasan, Liu, and Zhang () use leverage to investigate its effect on funding costs. However, all five papers show a negative relationship between solvency and funding costs.…”

“…Our selection of explanatory variables in the funding equation largely follows the existing literature. In particular, the literature on market discipline (see Section ) suggests that solvency is one of the most important explanatory variables for funding costs (Aymanns et al, ; Babihuga and Spaltro, ; Gambacorta and Shin, ; Hasan et al, ).…”

“…Since banks underlie different dynamics than non‐financial companies when determining their default boundaries and CDS spreads, we include bank‐specific variables. Net income (NI) is used following Aymanns et al (), Gambacorta and Shin () and Hasan et al () as it affects funding costs by changing the value of a bank's underlying assets. Bank regulation and supervision, deposit guarantee schemes and implicit government guarantees (including the underpriced liquidity insurance via access to central bank ELA for illiquid and often insolvent banks) are also bank‐specific characteristics .…”

Integrating Solvency and Liquidity Stress Tests

“…Higher funding costs also reduce the capital ratio (an increase of funding costs by 1 percent reduces CAR by 0.3 percent on average). Aymanns and others (2016) document that a decline in solvency ratios leads to higher unsecured funding costs, and decline in net interest margin. Overall, they find that a 1 percentage point decline in CAR leads to a 0.02 percentage-point increase in average funding costs, and a 0.04 percentage-point increase for wholesale funding costs.…”

C: Financial Operations and Services

“…166, no. 1082(March 2016 Banks across the United Arab Emirates boast an aggregate Tier 1 capital ratio of 16.6 per cent and a liquid assets ratio of 17.4 per cent and while the sector as a whole is in good shape, liquidity challenges are emerging as government and public sector deposits are drawn down following the collapse in oil prices. In an attempt to bolster the banking sector, the United Arab Emirates Banks Federation is busy initiating a series of measures including improvements to mobile banking services, taking a more consistent approach to applying sharia law in finance, and providing additional support to small and medium sized enterprises.…”