IMF paper sheds light on solvency and liquidity interactions

New data helps highlight the extent of solvency and liquidity interactions for banks during periods of market turbulence, which could lead to improvements in stress testing, according to an International Monetary Fund working paper published on May 15.

Laura Valderrama, Michael Sigmund and Stefan Schmitz note how falling capital buffers during a crisis gradually increase bank funding costs, and higher funding costs can erode capital buffers due to the “back-book effect” and as risk-sensitive investors demand more compensation.

They turn to a newly constructed dataset of advanced economy banks to gauge the extent of these effects, publishing the results in Bank Solvency and Funding Cost: New Data and New Results. They find “more sizeable effects” than in much of the literature, observing that a 100 basis point increase in regulatory capital leads to a 105bp decrease in funding costs.

“Our analysis suggests that, by incorporating the dynamic interaction between solvency and funding costs in the 2014 EU-wide stress test, stressed capital ratios could be depleted by a further half of the capital shortfall estimated in the original [European Banking Authority] analysis,” the authors say.