The interaction of liquidity risk and bank solvency via asset monetisation mechanisms

Alejandro Ferrer and Ana Molina
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Alejandro Ferrer: BANCO DE ESPAÑA
Ana Molina: BANCO DE ESPAÑA

No 2509, Occasional Papers from Banco de España

Abstract: In a liquidity stress scenario, banks may need to urgently monetise assets to meet deposit outflows. This can be done by either selling the assets or using them as collateral in financing operations. In a context of crisis, executing these financing transactions with private counterparties may be constrained, making the transactions with the central bank particularly relevant. The sale of assets classified at amortised cost will result in the materialisation of any accumulated unrealised losses, adversely affecting the banks’ profitability. Alternatively, central bank financing prevents the materialisation of unrealised losses, which, however, limit the amount of financing that can be obtained through this mechanism, as it is based on the market value of the collateral provided. In this case, the increase in interest expenses associated with the funds obtained from the central bank will also impact the bank’s profitability. All these negative effects on profitability ultimately affect solvency and can exacerbate the initial liquidity crisis. Thus, there is a link between liquidity stress and solvency deterioration in which unrealised losses play a significant role. Drawing on Spanish banking system data, we examine this connection in various simulation exercises, looking at its nature and strength under each mechanism (asset sale and pledge). The data show a growing weight of government debt classified at amortised cost on the balance sheets of Spanish banks in recent years, as well as an increase in the associated unrealised losses during the period of rising interest rates, especially in 2022, and in 2023.

Keywords: government debt; debt held at amortised cost; unrealised losses; LCR; liquidity stress; central bank liquidity facilities (search for similar items in EconPapers)
JEL-codes: E43 G17 G21 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2025-05
New Economics Papers: this item is included in nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:bde:opaper:2509e

DOI: 10.53479/39785

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