Are Banks' Below-Par Own Debt Repurchases a Cause For Prudential Concern?

Abstract

Leading up to the implementation of Basel III, European banks repurchased below-par debt securities. Banks are subjected to a prudential filter that excludes unrealized gains on liabilities from changes in own credit standing from the calculation of capital ratios. By repurchasing securities, unrealized gains become realized and increase Core Tier 1 capital. We show that poorly capitalized banks repurchased securities and lost about e9.1bn in premiums to compensate debt holders. Banks also repurchased the most loss-absorbing securities, for which they paid the highest premiums. These premiums increase with leverage and in times of stress. Hence debt repurchases are a cause for prudential concern.