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

Abstract

This paper presents new evidence on the empirical relationship between bank solvency and funding costs. Building on a newly constructed data set drawing on the supervisory data of 54 large banks from six advanced countries over 2004–2013, we use a simultaneous equation approach with panel data to estimate the contemporaneous interaction between solvency and funding costs. Our results and test statistics show that these two are (a) determined simultaneously and (b) more pronounced than suggested by the existing empirical literature. A 100‐bps increase in regulatory capital ratios is associated with a decrease of bank funding costs of about 113 bps. A 100‐bps increase in funding costs reduces regulatory capital buffers by 48 bps. Applying our estimation results to the 2014 EU‐wide stress test reveals that neglecting the solvency‐funding cost nexus leads to the systematical and significant underestimation of the impact of shocks on bank capital ratios.

Liquidity at Risk

“…Consequently, independently conducted solvency and liquidity stress tests will fail to identify the regions where failure arises through the interaction of solvency and liquidity rather than through one channel alone, and thus will underestimate the risk of failure. These results are consistent with the observations in Schmitz et al (2019), but push their conclusions further, showing that neglecting the liquidity-solvency nexus not only leads to the underestimation of solvency risk, but also of liquidity risk. The degree to which the credit risk is underestimated depends on the model parameters, balance sheet composition and sensitivities to risk factors.…”

“…Du et al (2019) present empirical evidence that indicators of credit quality affect counterparty choice, with the consequence that creditworthiness affects the volume rather than the price of shortterm funding. Schmitz et al (2019) present evidence on the relationship between bank solvency and funding costs and show that neglecting the solvency-liquidity nexus leads to a significant underestimation of the impact of shocks on bank capital ratios.…”

“…Many theoretical and empirical studies have pointed to the importance of interactions between solvency and liquidity risk (Bernanke, 2013;Cecchetti and Kashyap, 2018;Farag et al, 2013;Morris and Shin, 2016;Pierret, 2015;Rochet and Vives, 2004;Schmitz et al, 2019;Basel Committee on Banking Supervision, 2015). Interactions between solvency and liquidity are present in models of bank runs and debt roll-over coordination failures (Allen and Gale, 1998;Diamond and Rajan, 2005;Rochet and Vives, 2004).…”

Determinants of banks’ liquidity: A French perspective on interactions between market and regulatory requirements

“…To this end, Schmitz et al (2019) estimate empirically the interactions between solvency and funding costs and highlight four channels of transmission between the two kinds of risks: uncertainty about the quality of assets, fire sales, bank profitability and bank solvency. Through a theoretical model, Kashyap et al (2017) find that credit risk and run risk endogenously interact, showing that capital regulation generates more lending while liquidity regulation deteriorates it.…”

Determinants of Banks’ Liquidity: A French Perspective on Interactions between Market and Regulatory Requirements

“…To this end, Schmitz et al (2019) estimate empirically the interactions between solvency and funding costs and highlight four channels of transmission between the two kinds of risks: uncertainty about the quality of assets, fire sales, bank profitability and bank solvency. Through a theoretical model, Kashyap et al (2017) find that credit risk and run risk endogenously interact, showing that capital regulation generates more lending while liquidity regulation deteriorates it.…”