Market stigma and bank capital

The Great Financial Crisis exposed vulnerabilities in the quality and quantity of banks’ capital. It was the catalyst for increasing regulatory capital requirements, including the introduction of macroprudential buffers that can be used during economic downturns to incentivize banks to continue providing credit to the economy instead of engaging in excessive de-leveraging or de-risking behaviors. However, market pressure to maintain or even increase capital ratios can constrain banks in using their buffers during economic downturns. Hence, concerns with higher funding costs can be one of the reasons why capital ratios in Europe did not decrease, meaning that banks did not dip into their buffers during the onset of the COVID-19 crisis, despite a large release of regulatory capital buffers.

This paper investigates the relationship between banks’ solvency ratios and their funding costs using a proprietary dataset from Banco de Portugal for 21 Portuguese banks from 2006 to 2020. The paper focuses on how market discipline affects this relationship. The results suggest that the relationship between solvency and funding costs is negative and more pronounced during economic downturns. The relationship is stronger for market-based financing sources in comparison to deposits. Using a breakpoint analysis, the paper finds that investors are more likely to penalize the same absolute deterioration in solvency levels when banks are already in a fragile position. The findings support the hypothesis that fear of market stigma may make banks reticent to use buffers in times of stress.

Click here to go to the paper by Fátima Silva, Lucas Avezum, and Helena Carvalho.