Systemic Risk and the Solvency-Liquidity Nexus of Banks

Abstract

This paper highlights the empirical interaction between solvency and liquidity risks of banks that make them particularly vulnerable to an aggregate crisis. In line with the literature explaining bank runs based on the quality of the bank’s fundamentals, I find that banks lose their access to short-term funding when markets expect they will be insolvent in a crisis. 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 capital does not only act as a loss-absorbing buffer; it also ensures the confidence of creditors to continue to provide funding to the banks in a crisis.

Keywords: capital shortfall, funding liquidity risk, short-term funding

JEL Classification: G01, G21, G28