Bank solvency risk and funding cost interactions in a small open economy: evidence from Korea

Summary

Focus

When banks are hit by a shock large enough to compromise their solvency, they are perceived as riskier by others. This makes it difficult for them to fund themselves at convenient rates. In this way, solvency risk can increase funding costs. Similarly, if a bank experiences a persistent increase in funding costs, its business model and ability to generate profits on a sustainable basis might be called into question. This may increase its solvency risk. Solvency risk and funding costs are thus two forces that can interact with and feed upon each other. Macroprudential policies may affect this interaction by improving the solvency position of banks.

Contribution

We study the interaction between solvency risk and funding costs using two data sets that collect detailed information at the quarterly frequency for Korean commercial banks. We use unique data on marginal funding costs at the bank level. This is the right measure to look at when analysing solvency risk and funding cost interactions. We analyse the effect that FX-related macroprudential policies implemented in recent years had on the interaction between funding costs and solvency risk.

Findings

We show that an economically meaningful two-way negative interaction exists between solvency risk and marginal funding costs. A 100 basis point increase in marginal funding costs is associated with a 155 basis point reduction in the regulatory capital ratio. In turn, a 100 basis point increase in the regulatory capital ratio is associated with a 77 basis point decrease in marginal funding costs. The findings pass a series of robustness checks. We also show that using average funding costs, as normally done in the literature, can lead to the wrong conclusion about the link between solvency risk and funding costs. FX-related macroprudential measures were able to affect the negative interaction by muting the effect that marginal funding costs have on solvency risk.

Abstract

Using proprietary balance sheet data for Korean banks and a simultaneous equation model, we document that increased marginal funding costs lead to larger solvency risk (as measured by the Tier 1 regulatory capital ratio), which, in turn, leads to larger marginal funding costs. A 100 bp increase in marginal funding costs (solvency risk) is associated with a 155 (77) bp increase in solvency risk (marginal funding costs). The findings of an economically and statistically significant relationship are robust to considering different proxies for solvency risk, types of banks, interest rate regimes, and interest margin management strategies. They also hold irrespective of the funding profile considered. FX-related macroprudential policies can affect the negative feedback loop by muting the effect of marginal funding costs on solvency risk. Our findings can inform the calibration of macroprudential stress tests.

JEL classification: C50, G00, G10, G21

Keywords: solvency risk, funding cost, simultaneous equation model, stress testing, macroprudential policy, bank business models