Series: Occasional Papers. 2509.
Author: Alejandro Ferrer and Ana Molina.
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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. This trend is also observed among major European banks. There is some heterogeneity in the volume of unrealised losses among Spanish banks, which would be partly related to their level of solvency and liquidity. The simulation exercises carried out, based on the situation of the main Spanish banks in December 2023, show that the aggregate impact of a liquidity stress scenario would be limited in terms of solvency. However, it could lead to a greater deterioration of solvency if accompanied by an increase in short and long-term interest rates. In this context, the use of assets as collateral in financing operations with the central bank avoids the materialisation of unrealised losses and can reduce the financial cost of asset monetisation. This mechanism can largely prevent liquidity stress situations from ultimately weakening banks’ solvency.