28 January 2021

SUERF: Buffer usability and potential stigma effects

In light of the Covid-19 pandemic and its effects on the economy and financial markets, supervisors and policy makers at the international level are concerned that banks could refrain from using its capital buffers to support lending due to pay-out restrictions following the breach of the combined buffer requirement (CBR).

In this note we analyze potential impediments to buffer usability by banks. In particular, possible stigma effects arising from additional tier 1 (AT1) coupon restrictions are discussed as a crucial obstacle to buffer usability leading to a negative spill over effect on the overall bank funding cost and finally to a significant decline in credit supply. We run a series of empirical tests to asses the effects of a shrinking distance to the maximum distributable amount (MDA) threshold which reject the hypothesis that stigma effects are significant. Based on our findings, we reflect on the suggested ways to redesign the capital buffer framework to address possible shortcomings. In this regard, we provide a preliminary assessment of potential policy options, also given that the Basel Committee as part of its longer-term evaluation of the Basel III reforms will review the effectiveness of the buffer framework and in light of the macroprudential review of the European Commission.

1. Introduction

The covid-19 pandemic has led to unprecendented challenges. Its overall impact on the economies and on financial markets is far from being known. Recent developments due to second covid-19 waves have darkened the economic outlook, but signs of a sooner recovery are looming given the recent breakthrough in the research of Covid vaccines. Banks have been able to weather the effects of the covid-19 pandemic so far. Higher regulatory capital ratios which were introduced after the great financial crises have been successful in mitigating systemic risks and in strengthening the resilience of the banking sector.

But, the financial stability environment remains challenging, since losses have not fully materialized yet due to unprecedented government measures. It is expected that the phasing-out of support measures will force down banks’s capital ratios in the near future. In this regard, buffer usability will be crucial to avoid unintended deleveraging effects and a credit crunch to the economy.

Concerns at international level exist that banks are not willing to draw on their capital and to dip into their buffers due to possible stigma effects. In this note stigma effects are associated with higher funding costs for banks given an increase in the probability of pay-out restrictions due to shrinking distances to the maximum distributable amount (MDA) threshold.

Falling below the MDA threshold and hence, a breach of the combined buffer requirement (CBR) instead automatically leads to proportional restrictions of profit distributions for dividends/share buybacks, AT1 coupons and bonuses as well as the requirement by banks to establish a capital conservation plan. In the case of losses, it may even result in a de facto restriction of pay-outs, thus preserving capital in the ailing bank. To that effect, capital buffer requirements differ legally from Pillar 1 and Pillar 2 requirements as a breach of the CBR does not require supervisory action.2 In addition, the different nature of the capital conservation buffer, the global and other systemically important institutions buffer, the systemic risk buffer and the countercyclical capital buffer allows designated authorities to address systemic risks effectively.3

The framework, which was put in place in 2014, is now well established and understood by investors. Its consequences are transparent and predictable and they are priced in AT1 instruments and other affected/relevant financial instruments.

Although the legal consequences of an MDA breach are not severe, potential stigma effects are cosidered as possible impediment to buffer usability. Higher funding costs due to stigma effects would ultimately lead to a decline in credit supply with unintended negative repercussions on the real economy.

2. Negative impact of potential stigma effects of using capital buffers are overstated

To assess whether stigma effects of using capital buffers exist and whether these effects are significant, in the first place, we consider recent examples of AT1 coupon cancellations or non-call events and their implications on AT1 fundings costs as well as on banks’ weighted average cost of capital (WACC). In the second place, we run a series of empirical tests to check the hypothesis whether stigma effects are significant.

2.1 Higher funding costs of AT1 have little impact on bank funding costs and on loan pricing

Banks’ decision to grant loans crucially depends on funding costs. Regarding the current regulation of the buffer framework AT1 coupon restrictions are discussed as one crucial obstacle to buffer usability. Given that additional tier 1 (AT1) is the second highest quality of regulatory capital, it bears risks by discretionary coupon cancellations and by restrictions on distrubutions in case of an MDA breach. On the one hand, coupon cancellations support banks’ common equity tier 1 (CET1) capital ratio, on the other hand, banks may be reluctant to cancel AT1 coupons to preserve both investor confidence and access to funding.

To date, AT1 investors have only suffered a very limited number lossess involving low amounts. This limits the size of our sample. It consists of five AT1 extension events and two other cases. The latter referes to Banco Popular’s capital securities (AT1 and Tier 2), which were written down on June 6, 2017, and Bremer Landesbank’s AT1 coupon cancellation on June 23, 2017. Chart 1 shows that the cancellation of the AT1 coupons by Bremer Landesbank did not lead to significant negative price effects of its outstanding AT1 instruments.4 The ask-price of its AT1 instrument with a 7.78% coupon (left-hand panel of chart 1) recovers within 2 months. The ask-price of the bank’s AT1 instrument with a 9.5% coupon takes four months to recover. The blue lines in chart 1 refer to the price of the bank’s 10-year unsecured senior benchmark bond. It remained stable when the coupons were cancelled.

Chart 1: No significant impact of the coupon cancellation of Bremer Landesbank on the price of its AT1 instruments5 (orange line) or that of its senior unsecured debt instruments (blue line)

According to the sceptics of buffer usability, both events should have also led to disruptions of the EUR AT1 market, but this market proved resilient. The blue line in chart 3 shows that the broader market even increased in the face of the two events (the two left red vertical lines). According to Fitch, the market’s resilience was due to the more stable and mature market, which had been aided in part by regulatory developments (especially by the increasing macroprudential buffer requirements since 2014), and adequate CET1 ratios at most issuing banks in Europe.6

As AT1 instruments are perpetual bonds in Europe, refinancing needs tend to be limited and largely endogenous to the decision of the bank. However, investors expect banks to call at the earliest possible point in time.7 In 2019 Santander (February 12) and in 2020 Deutsche Bank (March 11), Aareal Bank (March 20) and Lloyds (May 22) extended AT1 bonds. Still, the market impact of these AT1 extensions was very limited, with short term price losses of the extended bonds and rather quick price recoveries (see charts in the annex). Santander’s AT1 price (orange line in the left-hand panel of chart 2) remained stable in the face of the extension of the instrument. The price of Lloyds’ AT1 instrument even increased slightly and for a short period after the extension. Also, its 5-year CDS spread decreased after the event. The price reactions for Deutsche Bank (right-hand panel) and Aareal Bank were more pronounced. Since prices have also been affected by the Covid-19 pandemic, it is difficult to determine the exact impact of the extension events. This notwithstanding, both AT1 prices recovered within three months. The CDS spread of Deutsche Bank recovered fully within three months; that of Aareal Bank remained stable. The events did not have a negative impact on the EUR AT1 market (chart 3).

The charts also show that the banks’ unsecured funding costs (proxied by their CDS spreads for their five-year unsecured senior bonds) fell significantly after the banks’ failure to call their AT1 instruments. It seems that the markets think that such action strengthens the respective bank and reduces the probability of default. Holders of AT1 instruments may have lost out but unsecured bond holders benefited.

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