The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
Stefan Schmitz, Michael Sigmund, and Laura Valderrama
INTERNATIONAL MONETARY FUND
This paper presents new evidence on the empirical relationship between bank solvency and
funding costs. Building on a newly constructed dataset drawing on supervisory data for
54 large banks from six advanced countries over 2004-2013, we use a simultaneous equation
approach to estimate the contemporaneous interaction between solvency and liquidity. Our
results show that liquidity and solvency interactions can be more material 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 105 bps. A 100 bps increase in 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 stress testing. Our analysis suggests that neglecting the dynamic
features of the solvency-liquidity nexus in the 2014 EU-wide stress test could have led to a
significant underestimation of the impact of stress on bank capital ratios.