Max Headroom: Discretionary Capital Buffers and Bank Risk

This paper examines the association between discretionary capital buffers, capital requirements, and risk for European banks. The discretionary buffers are banks' own buffers, or headroom: the difference between reported and required capital. I exploit capital requirements data that banks started to disclose since the release of a 2015 European Banking Authority opinion. Results using detailed SREP and Pillar 2 data of the largest 99 European banks over 2013-2019 show that less headroom is associated with increased bank risk. An additional examination reveals a positive association between headroom and stress test results for banks subjected to the Single Supervisory Mechanism, a result that runs against supervisory requirements

Max Headroom: Discretionary Capital Buffers and Bank Risk

This paper examines the association between discretionary capital buffers, capital requirements, and risk for European banks. The discretionary buffers are banks' own buffers, or headroom: the difference between reported and required capital. I exploit capital requirements data that banks started to disclose since the release of a 2015 European Banking Authority opinion. Results using detailed SREP and Pillar 2 data of the largest 99 European banks over 2013-2019 show that less headroom is associated with increased bank risk. An additional examination reveals a positive association between headroom and stress test results for banks subjected to the Single Supervisory Mechanism, a result that runs against supervisory requirements

How does the market price pension accruals?

We use a cross-sectional valuation model that distinguishes between the operating and financial activities of the firm to examine the repercussions of three main alternative measures of pension expense. The GAAP Method recognizes a smoothed net pension expense, the NETCOST Method includes the excess of interest cost over the actual return on pension plan assets, if and only if this number is positive, and the FV Method substitutes the fair value in place of the smoothed pension expense. Three alternative fair value estimates of pension expense are examined: the first includes the expected return on plan assets and fair value other costs; the second includes the actual return on plan assets and net fair value other costs; the third includes the expected and the unexpected return on plan assets, along with net fair value other costs. Results from OLS regressions are consistent with the GAAP Method being relevant while the market appears to value the unexpected return included in the FV Method. Additional analyses from jack-knife (out-of-sample) regressions confirm the OLS findings. Further, we show that the multiples assigned to the alternative measures of pension expense differ based on the funding status of pension plans. The results are robust to various sensitivity checks

Are banks’ below-par own debt repurchases a cause for prudential concern?

In the lead-up to the implementation of Basel III, European banks bought back debt securities that traded at a discount. Banks engaged in these Liability Management Exercises (LMEs) to realize a fair value gain that the accounting and prudential rules exclude from regulatory capital calculations, this to safeguard the safety and soundness of the banking system. For a sample of 720 European LMEs conducted from April 2009 to December 2013, I show that banks lost about 9.3 billion euros in premiums to compensate investors for parting from their debt securities. This amount would have been recognized as Core Tier 1 regulatory capital, if regulation would accept the recognition of fair value gains on debt. The premiums paid are particularly high for the most loss absorbing capital securities. More importantly, the premiums increase with leverage and in times of stress, right when conserving cash is paramount to preserve the safety and soundness of the banking system. These results weaken the case of the exclusion from regulatory capital of unrealized gains that originate from a weakened own credit standing

A Primer on Regulatory Bank Capital Adjustments

To calculate regulatory capital ratios, banks have to apply adjustments to book equity. These regulatory adjustments vary with a bank’s solvency position. Low-solvency banks report values of Tier 1 capital that exceed book equity. They use regulatory adjustments to inflate regulatory solvency ratios such as the Tier 1 leverage ratio and the Tier 1 risk-based capital ratio. In contrast, highly solvent banks report Tier 1 capital that is lower than book equity. These banks adjust their solvency ratios downward for prudential reasons, despite their resilient solvency levels. These results weaken the case for regulatory adjustments. The decreasing relationship between regulatory adjustments and bank solvency reflects the cost of deleveraging, a cost that demonstrates the resistance of banks to substituting equity for debt

Are banks’ below-par own debt repurchases a cause for prudential concern?

In the lead-up to the implementation of Basel III, European banks bought back debt securities that traded at a discount. Banks engaged in these Liability Management Exercises (LMEs) to realize a fair value gain that the accounting and prudential rules exclude from regulatory capital calculations, this to safeguard the safety and soundness of the banking system. For a sample of 720 European LMEs conducted from April 2009 to December 2013, I show that banks lost about 9.3 billion euros in premiums to compensate investors for parting from their debt securities. This amount would have been recognized as Core Tier 1 regulatory capital, if regulation would accept the recognition of fair value gains on debt. The premiums paid are particularly high for the most loss absorbing capital securities. More importantly, the premiums increase with leverage and in times of stress, right when conserving cash is paramount to preserve the safety and soundness of the banking system. These results weaken the case of the exclusion from regulatory capital of unrealized gains that originate from a weakened own credit standing

Are banks’ below-par own debt repurchases a cause for prudential concern?

Leading up to the implementation of Basel III, European banks repurchased below-par debt securities. Banks are subjected to a prudential filter that excludes unrealized gains on liabilities from changes in own credit standing from the calculation of capital ratios. By repurchasing securities, unrealized gains become realized and increase Core Tier 1 capital. We show that poorly capitalized banks repurchased securities and lost about e9.1bn in premiums to compensate debt holders. Banks also repurchased the most loss-absorbing securities, for which they paid the highest premiums. These premiums increase with leverage and in times of stress. Hence debt repurchases are a cause for prudential concern

Are banks’ below-par own debt repurchases a cause for prudential concern?

Leading up to the implementation of Basel III, European banks repurchased debt securities that traded below par. Banks are subjected to a prudential filter that excludes unrealized gains on liabili- ties from changes in own credit standing from the calculation of capital ratios. By repurchasing debt securities below par, unrealized gains become realized and increase Core Tier 1 capital. Using data of 720 European Liability Management Exercises (LMEs) conducted between April 2009 and De- cember 2013, we show that poorly capitalized banks repurchased securities and lost about 9.1bn euro in premiums to compensate debt holders. Banks also repurchased the most loss-absorbing securities, for which they paid the highest premiums. These premiums increase with leverage and in times of stress. Hence debt repurchases are a cause for prudential concern