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

Blog Post

Germany’s savings banks: uniquely intertwined with local politics

German savings banks, known as Sparkassen, form an important feature of the country's banking assets. Unlike in other European countries, German Sparkassen also hold direct links with local political communities. This post focuses on the Sparkassen's structural links and relationships with elected politicians. Three findings which do not appear to have been specifically documented previously stand out.

By: Jonas Markgraf and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: July 18, 2018
Read article More on this topic More by this author

Blog Post

Economy of Intangibles

Economists have been discussing the implications of the rise of the intangible economy in relation to the secular stagnation hypothesis, and looking more generally into the policy implications it has for taxation. We review some recent contributions.

By: Silvia Merler Topic: Finance & Financial Regulation Date: July 16, 2018
Read about event

Upcoming Event

Sep
3-4
08:30

Bruegel Annual Meetings 2018

The 2018 Annual Meetings will be held on 3-4 September and will feature sessions on European and global economic governance, as well as finance, energy and innovation.

Speakers: Maria Åsenius, Richard E. Baldwin, Carl Bildt, Nadia Calviño, Maria Demertzis, Mariya Gabriel, Péter Kaderják, Joanne Kellermann, Jörg Kukies, Emmanuel Lagarrigue, Philippe Lespinard, Montserrat Mir Roca, Dominique Moïsi, Jean Pierre Mustier, Ana Palacio, Jean Pisani-Ferry, Lucrezia Reichlin, Norbert Röttgen, André Sapir, Jean-Claude Trichet, Johan Van Overtveldt, Margrethe Vestager, Reinhilde Veugelers, Thomas Wieser, Guntram B. Wolff and Georg Zachmann Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Brussels Comic Strip Museum, Rue des Sables 20, 1000 Brussels
Read article Download PDF More on this topic

Policy Contribution

Cryptocurrencies and monetary policy

Can cryptocurrencies acquire the role of money? And what are the implications for central banks and monetary policy? Read the policy contribution to understand what challenges cryptocurrencies have to overcome to replace official currencies.

By: Grégory Claeys, Maria Demertzis and Konstantinos Efstathiou Topic: Finance & Financial Regulation Date: June 28, 2018
Read article More on this topic

Blog Post

European bank mergers: domestic or cross-border?

As the European economy recovers from the global financial crisis, bank mergers are back on the agenda. While cross-border mergers have been predicted before, most European bank mergers have been domestic until now. What are the odds of cross-border mergers in the upcoming bank-consolidation wave?

By: Patty Duijm and Dirk Schoenmaker Topic: Finance & Financial Regulation Date: June 21, 2018
Read article Download PDF More on this topic More by this author

Working Paper

EU financial services policy since 2007: crisis, responses and prospects

This paper presents a holistic overview and assessment of the European Union (EU)’s financial services policy since the start of its financial crisis in mid-2007. Its emphasis is on public policy initiatives and developments at the European level, including those specific to the euro area.

By: Nicolas Véron Topic: Finance & Financial Regulation Date: June 21, 2018
Read article More on this topic More by this author

Podcast

Podcast

Director’s Cut: Making Europe financially literate

This week's guest on the Director’s Cut of ‘The Sound of Economics’, Annamaria Lusardi, raises the urgent need to adopt policies that seek to improve people’s understanding of financial concepts and risks, in conversation with Bruegel deputy director Maria Demertzis.

By: The Sound of Economics Topic: Finance & Financial Regulation Date: June 19, 2018
Read article More on this topic More by this author

Blog Post

Enhancing the ESM lending toolkit through a precautionary credit line

Strengthening the ESM can help to prevent crises and enhance deeper financial integration in the euro area. Yet, mislabelling the ESM as “European Monetary Fund” will not do the trick. Instead, a revamp of its precautionary credit line could create a meaningful instrument, built on the existing policy framework, by incentivising strong economic policies and guarding against financial market turbulence. However, the devil is in the details. The design of such a facility has to be well thought through, to navigate difficult trade-offs.

By: Jochen Andritzky Topic: Finance & Financial Regulation Date: June 11, 2018
Read article More on this topic More by this author

Blog Post

The Italian mini-BOT debate

Talks of parallel currency are not new in Italy. But one of the proposals – the so called mini-BOT – has made it into the government contract that underpins the current League-M5S coalition. We review what has been said about these proposals.

By: Silvia Merler Topic: Finance & Financial Regulation Date: June 11, 2018
Read about event More on this topic

Past Event

Past Event

What next for banking union?

This event will discuss the future of Banking Union.

Speakers: Maria Demertzis, Philipp Hildebrand and Guntram B. Wolff Topic: Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 8, 2018
Read article More on this topic

Blog Post

Mini-BOT in the government programme of the Five Star Movement and the League

The economic evaluation of mini-BOT very much depends on its specific characteristics. Overall it appears to be a blend of an inferior security and inferior money. More important than its specific characteristics is the message that the implementation of the mini-BOT would send about Ital-exit: inevitably, given what the League and its representatives have said and written, the mini-BOT would be seen as a first step in the exit of Italy from the euro, rekindling denomination risk attached to Italian securities.

By: Francesco Papadia and Alexander Roth Topic: Finance & Financial Regulation Date: June 5, 2018
Read article More by this author

Podcast

Podcast

Director's Cut: Central banking and the problem of unelected power

Bruegel director Guntram Wolff discusses current tensions in central banking governance with Paul Tucker, former deputy governor of the Bank of England and author of the newly released book 'Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State'.

By: The Sound of Economics Topic: Finance & Financial Regulation, Global Economics & Governance Date: June 5, 2018
Load more posts