Bank Solvency and Funding Cost: New Data and New Results

Abstract

This paper presents new evidence on the empirical relationship between bank solvency and funding costs. Building on a newly constructed database drawing on supervisory data, we use a simultaneous equation approach in a panel set-up to estimate the contemporaneous interaction between bank solvency and bank funding costs. Our results show that this interaction can be more material than suggested by the empirical literature; it usually focuses on the unidirectional effects of solvency on funding costs which results in severe endogeneity and simultaneity biases. A 100 bps increase in regulatory capital ratios is associated with a decrease of our proxy for bank funding costs, CDS spreads, of about 110 bps. A 100 bps increase in this proxy of bank funding costs reduces regulatory capital buffers by 32 bps. We also find evidence of non-linear effects between solvency and funding costs. Understanding the impact of solvency on funding costs is particularly relevant for macroprudential stress testing (incl. second round effects, such as the interaction between solvency and funding costs) and for impact assessments of macroprudential policy measures. Our analysis suggests that stress test models that do not take into account the interaction between solvency and funding costs are likely to underestimate the impact of stress on financial stability.