Systemic risk and the solvency-liquidity nexus of banks

Diane Pierret

No 2014038, LIDAM Discussion Papers CORE from Université catholique de Louvain, Center for Operations Research and Econometrics (CORE)

Abstract: This paper highlights the empirical interaction between solvency and liquidity risks of banks that make them particularly vulnerable to an aggregate crisis. I find that banks lose their access to short-term funding when markets expect they will be insolvent in a crisis. Conversely, the expected amount of capital a bank should raise to remain solvent in a crisis (its capital shortfall) increases when the bank holds more short-term debt (has a larger exposure to funding liquidity risk). This solvency-liquidity nexus is found to be strong under many robustness checks and to contain useful information for forecasting the short-term balance sheet of banks. The results suggest that the solvency-liquidity interaction should be accounted for when designing liquidity and capital requirements, in contrast to Basel III regulation where solvency and liquidity risks are treated separately.

Keywords: capital shortfall; funding liquidity risk; short-term funding (search for similar items in EconPapers)
JEL-codes: G01 G21 G28 (search for similar items in EconPapers)
Date: 2014-11-05
New Economics Papers: this item is included in nep-ban and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Journal Article: Systemic Risk and the Solvency-Liquidity Nexus of Banks (2015)
Working Paper: Systemic risk and the solvency-liquidity nexus of banks (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:cor:louvco:2014038

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