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The solvency and funding cost nexus - the role of market stigma for buffer usability
G00 - General
G21 - Banks; Other Depository Institutions; Mortgages
G28 - Government Policy and Regulation
In this paper, we investigate the relationship between the banks’ solvency ratio and their funding costs using a proprietary dataset from Banco de Portugal for 21 Portuguese banks from 2006 to 2020. In light of the discussion on impediments to capital buffer usability by banks, we focus on the importance of market discipline to this relationship. Our results suggest that the relationship between solvency and funding costs is negative and state-dependent, i.e. market participants become more sensitive to changes in solvency during economic downturns. The relationship is stronger for market-based financing sources in comparison to deposits. Finally, we use a breakpoint analysis and find that investors are more likely to penalize the same absolute deterioration in solvency levels when banks are already in a fragile position. Our findings support the hypothesis that fear of market stigma may make banks reticent to use buffers in times of stress.