Finance Cluster Seminar: Are banks’ below-par own debt repurchases a cause for prudential concern?
In the lead-up to the implementation of Basel III, European banks repurchased debt securities that traded below par. Banks engaged in these Liability Management Exercises (LMEs) to realize a fair value gain that prudential rules exclude from regulatory capital calculations. Many banks executed LMEs to augment Core Tier 1 capital, given that alternative methods were not feasible in practice. Using data of 720 European LMEs conducted between April 2009 and December 2013, we show that poorly capitalized banks in particular engaged in LMEs and lost about e9.1bn in premiums to compensate fixed-income investors for parting with their securities. This amount would largely be recognized as Core Tier 1 regulatory capital if regulation accepted the recognition of fair value gains on debt. Banks used their discretion to buy back the most lossabsorbing capital securities, for which they paid the highest premiums. More importantly, the premiums increase with leverage and in times of stress, when conserving cash is paramount to preserve the safety and soundness of the banking system. Our results weaken the case of the exclusion from regulatory capital of unrealized fair value gains that originate from a poor own credit standing