Bank solvency risk and funding cost interactions: Evidence from Korea

Abstract

Using proprietary balance sheet data for Korean banks and a simultaneous equation model, we use a unique measure of the cost of new funding to document that increased funding costs lead to larger solvency risk (as measured by regulatory capital), which, in turn, leads to larger funding costs. When including the great financial crisis in the sample, our estimates imply that a 100 basis points (bp) increase in the cost of new funding (regulatory capital) is associated with a 265 (23) bp increase in regulatory capital (cost of new funding). We show these results are robust to alternative measures of solvency risk and that the traditionally used measure of average funding costs (interest expense over interest-bearing liabilities) does not properly capture this two-way negative feedback loop. The strength of this link is weaker during periods of monetary policy tightening, and is not affected by the specific funding business model chosen by banks. Our findings can inform macroprudential stress-tests calibration.