Are Banks' Below-Par Own Debt Repurchases a Cause for Prudential Concern?
45 Pages Posted: 19 Aug 2014 Last revised: 20 Dec 2016
Date Written: October 20, 2014
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 Euro 9.3B 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.
Keywords: Banking, repurchases, subordinated debt, Basel III
JEL Classification: E58, G21, G28, G32, G35, M41
Suggested Citation: Suggested Citation