Blog Post

Who’s afraid of the AQR?

Banks have incentives to recapitalize in socially undesirable ways and to hide losses on their balance sheets. Will the comprehensive assessment solve these issues by forcing European significant banks to recognize losses and to recapitalize by issuing new equity instead of deleveraging?

By: and Date: October 24, 2014 Topic: Finance & Financial Regulation

Banks have incentives to recapitalize in socially undesirable ways and to hide losses on their balance sheets. Will the comprehensive assessment solve these issues by forcing significant European banks to recognize losses and to recapitalize by issuing new equity instead of deleveraging? Between January and July 2014 euro area banks have announced equity issuance of about 38 billion, of which 28 billion has currently been issued. Over 75% comes from banks in Greece, Spain, Italy and Portugal.  In addition, banks issued about 14 billion of Additional Tier 1 (AT1) capital, or CoCos. Here, banks in Spain, France and Germany have been big issuers. The total of 52 billion lies below earlier predictions of 80-130 billion of required recapitalization. In addition to the strengthening of their regulatory capital, banks also reported provisions and impairments totaling up to 135 billion.

Deleveraging is socially undesirable because the resulting contraction of credit hits growth of healthy firms

If banks have to recapitalize, they prefer deleveraging over issuing fresh capital because of two market failures. Banks prefer to increase their capital ratios by deleveraging over issuing fresh capital because (1) the cost of issuing fresh capital are born by the existing shareholders due to debt overhang and (2) because issuing capital is seen as a negative signal by the market due to information asymmetry (see e.g. Marinova et al. 2014 for review of relevant literature). Deleveraging is socially undesirable because the resulting contraction of credit hits growth of healthy firms.  This is not just theory: the empirical literature documents the negative effect of capital shocks on bank lending and the real economy (see e.g. Peek and Rosengren, 2000; Albertazzi and Marchetti, 2010; Jiménez et al. 2012).

Under existing regulation, supervisors can specify what capital ratio banks should have, but not in what way banks should recapitalize if they fall short of that ratio. To address the two market failures mentioned above supervisors currently have only two instruments: (1) enhance the transparency of bank’s balance sheets to reduce information asymmetry, and (2) impose tight deadlines for recapitalization which reduces the possibility to use deleveraging. The Comprehensive Assessment (CA), consisting of the asset quality review (AQR) and stress tests, should be seen in this light. By applying a uniform measure to determine the quality of banks’ balance sheets, the ECB aims to identify hidden bank losses. The limited time between the AQR, the publication of the results in the autumn and the deadline to recapitalize, stimulates problem banks to raise new capital. The deadlines to significantly improve capital ratios are too short for substantial deleveraging.

Because the stress tests are carried out on the basis of year-end 2013 figures, banks have an incentive to clean up their year-end 2013 balance sheets. To avoid capital shortfalls resulting from the CA, banks can issue fresh equity or convertible contingent bonds (CoCo’s, debt like contracts that convert to equity under certain pre-specified conditions) that count as Additional Tier 1 capital (AT1). Table 1 below shows capital and CoCo’s issuance in 2012, 2013 and 2014. Data was gathered manually from public sources.

Table 1 Capital and CoCos issuance between 2012 and 2014 (*)

* 2014 is up to and including July

year

Issued capital

Issued Coco’s

2012

 € 17 billion

€ 0

2013

 € 16 billion

€ 6.3 billion

2014

 € 28 billion

€ 14 billion

Between January and July European banks have announced to issue for about €38 billion in fresh capital and about €14 billion in CoCos. From the announced €38 billion of equity, about €28 billion has actually been issued. Compared to 2013 and 2012 capital issuance has substantially increased. On the one hand this can be explained by incentives provided by the CA. On the other hand, conditions in equity markets have also improved.

The ECB claims that since July 2013, more than €140 billion has been added in additional capital or by reducing business

In addition to the strengthening of their regulatory capital, these banks also reported provisions and impairments totaling up to €135 billion. Combining capital reinforcements and provisions, European significant banks have, since the beginning of 2014, been bolstering their balance sheets by over €180 billion. The ECB claims that since July 2013, more than €140 billion has been added in additional capital or by reducing business. Our figure is consistent with this claim. Because we do not consider deleveraging here, our numbers differ.

Figure 1 shows the distribution of capital issuance and impairments over countries. From the announced €38 billion of new equity, about €28 billion has currently been issued. Over 75% is from banks in Greece, Spain, Italy and Portugal.  Banks in Spain, France and Germany have been big issuers of AT1 capital, or CoCos, as a way to beef up their capital ratios. The CoCo-market has been growing since last year, when banks in Spain, Italy, Denmark and Belgium launched their first CoCo -deals. This year, euro area banks have issued over €14 billion of CoCos. The same banks reported provisions and impairments totaling up to €135 billion. Compared to other banks in euro area Member States, banks in Spain and Italy have been recognizing considerable amounts of losses. One explanation is that they have anticipated on the strict(er) measures for loss-recognition as applied in the AQR.

There is no clear relation between capital or CoCo issuances, and the risk-weighted capital ratio

If risk-weighted capital ratios are a sufficiently reliably proxy for the resilience of a bank, one might expect that predominantly banks with low risk-weighted capital ratios are bolstering their balance sheets. However, as the figure below suggests, there is no clear relation between capital or CoCo issuances, and the risk-weighted capital ratio. This might imply that the risk weighted capital requirements are not a reliable indicator of the banks’ resilience. Since banks are increasing their non-risk-based leverage ratios, the CA addresses this issue partly.

Conclusion

Banks might be be healthier than predicted or the stress test may be less strict than expected

The AQR has clearly provided banks with an incentive to clean-up their balance sheet and bolster the level of regulatory capital by issuing equity and AT1 capital. The amount of already issued and announced issues seems limited compared to earlier predictions of required recapitalization for euro area banks: €52 billion against predicted recapitalizations of €80-130 billion. One conclusion could be that European banks are healthier than predicted earlier. It could also mean that the stress test is less strict than expected. Only time will tell.

Read more on AQR

Fact of the week: Only 8% of banks says they will need to raise capital after AQR

An encouraging start for the ECB’s Big Bank Review


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read article More on this topic More by this author

Blog Post

Building a stable european deposit insurance scheme

Deposit insurance, like any insurance scheme, raises moral hazard concerns. Such concerns arising from European deposit insurance can be alleviated through a country-specific component in the risk-based premium for deposit insurance and limits on sovereign bond exposures on bank balance sheets. This column argues, however, that proposals to maintain national compartments in a new European Deposit Insurance Scheme are self-defeating, as such compartments can be destabilising in times of crisis.

By: Dirk Schoenmaker Topic: Finance & Financial Regulation Date: April 19, 2018
Read article More on this topic More by this author

Blog Post

The debate on euro-area reform

A paper jointly written by 14 French and German economists set off a debate about the reform of euro-area macroeconomic governance. We review economists’ opinions about it.

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 16, 2018
Read article More on this topic More by this author

Blog Post

Latvia’s money laundering scandal

Latvia’s third largest bank ABLV sought emergency liquidity from the ECB and eventually voted to start a process of voluntary liquidation, after being accused by US authorities of large-scale money laundering and having failed to produce a survival plan. What does it mean for the ECB?

By: Silvia Merler Topic: Finance & Financial Regulation Date: April 9, 2018
Read article More on this topic More by this author

Opinion

The Lesser Evil for the Eurozone

For three decades, the consensus within the European Commission and the European Central Bank on the need for market reforms and sound public finances has been strong enough to overcome opposition in small countries and outlast procrastination in large ones. Today, however, the Eurozone playing field has become a battleground.

By: Jean Pisani-Ferry Topic: Finance & Financial Regulation Date: April 4, 2018
Read article More by this author

Podcast

Podcast

Director's Cut: Developing deposit insurance in Europe

In this week’s Director’s Cut of ‘The Sound of Economics’ podcast, Bruegel director Guntram Wolff talks with Nicolas Véron, senior fellow at Bruegel, about the implementation of a European Deposit Insurance Scheme (EDIS), one of the three pillars needed for the completion of banking union.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: April 3, 2018
Read article More on this topic More by this author

Podcast

Podcast

Blockchain: The process and the future

Proponents of blockchain see it as the future – but when might it become the present? In this latest episode of ‘The Sound of Economics’ we welcome Julio Faura, global head of innovation at Banco Santander, and Johan Pouwelse, associate professor at Delft University of Technology, to help illuminate the blockchain concept and where it could be taking us.

By: The Sound of Economics Topic: Finance & Financial Regulation Date: March 29, 2018
Read article Download PDF More by this author

External Publication

European Parliament

Cash outflows in crisis scenarios: do liquidity requirements and reporting obligations give the SRB sufficient time to react?

Bank failures have multiple causes though they are typically precipitated by a rapidly unfolding funding crisis. The European Union’s new prudential liquidity requirements offer some safeguards against risky funding models, but will not prevent such scenarios. The speed of events seen in the 2017 resolution of a Spanish bank offers a number of lessons for the further strengthening of the resolution framework within the euro area, in particular in terms of inter-agency coordination, the use of payments moratoria and funding of the resolution process.

By: Alexander Lehmann Topic: European Parliament, Finance & Financial Regulation, Testimonies Date: March 28, 2018
Read about event More on this topic

Past Event

Past Event

Pension funds in the EU capital markets union

At this event, we assessed the prospects for funded pension schemes as a component of balanced retirement savings, and how the regulatory framework could become more supportive within the EU’s nascent capital markets union.

Speakers: Alexander Lehmann, Marina Monaco, Amlan Roy, Steve Ryan and Gisella van Vollenhoven-Eikelenboom Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: March 28, 2018
Read article More on this topic

External Publication

Capital Markets Union and the Fintech Opportunity

Fintech has the potential to change financial intermediation structures substantially. It could disrupt existing financial intermediation with new business models empowered by intelligent algorithms, big data, cloud computing and artificial intelligence.

By: Maria Demertzis, Silvia Merler and Guntram B. Wolff Topic: Finance & Financial Regulation Date: March 26, 2018
Read about event More on this topic

Past Event

Past Event

Bank assets and business models: addressing complexity

At this event, we discussed the lack of transparency and problems in valuing correctly significant parts bank assets in the euro area based on an extensive study by the Bank of Italy.

Speakers: Simon Ainsworth, Paolo Angelini, Josina Kamerling, Martin Merlin, Alexander Lehmann and Nicolas Véron Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: March 21, 2018
Read article More on this topic More by this author

Blog Post

Central banks in the age of populism

Two years of elections have shown that we live in an age of increasing political and economic populism. What are the consequences of that for central banks? We explore opinions about it, from both 2017 and more recently.

By: Silvia Merler Topic: Finance & Financial Regulation Date: March 19, 2018
Read article More on this topic

Opinion

China's “matryoshka” approach for debt-to-equity swaps could be good for banks, but bad for investors

The Chinese banking sector has enhanced its clean-up mechanism by introducing debt-to-equity swaps for the resolution of problem loans. While this allows banks to offload their stressed assets at a very low cost, it does not prevent banks’ exposure when we look closer at the so-called "state-owned funds" who are shareholders in the debt-to-equity swaps.

By: Alicia García-Herrero and Gary Ng Topic: Finance & Financial Regulation Date: March 8, 2018
Load more posts