Target capital ratio and optimal channel(s) of adjustment: a simple model with empirical applications to European banks

Abstract

Why do banks decide to reach their target capital ratio by selling assets and/or issuing new shares? To answer this question, we offer a simple framework in which each channel of adjustment is costly; underwriting and dilution costs for equity issuance, profit reduction and price impact for asset sale. We make the assumption that the aim of the bank is to minimize the total adjustment cost subject to the target's constraint and we derive its optimal strategy. The solution is formulated in terms of two critical thresholds for which we give an explicit formula. We then compare our model's predictions to the decisions taken by two European systemic banks (Deutsche Bank and UniCredit) to issue new shares in 2017 and for which the target ratio was publicly disclosed. We show that the predictions of the model are consistent with the observed decisions.

Do buffer requirements for European systemically important banks make them less systemic?

“…We also explore whether the different adjustment mechanisms to higher capital requirements impact SRISK once the SII buffer is implemented. Following Cohen and Scatigna (2016) and Braouezec and Kiani (2021), among others, we explore the impact on SRISK of four transmission the ESRB. 26 Our definitions are based on the dates when the SII status is effective.…”

“…Understanding which of these mechanisms dominates banks' behaviour towards increases in SII capital requirements is central to evaluating the implications of SII buffers. Broadly speaking, in response to higher capital requirements banks have four main options at their disposal (see Bank for International Settlements (2012), Cohen and Scatigna (2016) and Braouezec and Kiani (2021)). 11 Namely, a bank can either (1) issue new equity; (2) increase its retained earnings; (3) run down its assets; or (4) reduce its risk-weighted assets.…”

“…Following Cohen and Scatigna (2016) andBraouezec and Kiani (2021), among others, we explore the impact on SRISK of four transmission the ESRB.26 Our definitions are based on the dates when the SII status is effective. The first G-SII list took effect in January 2012, and since then it is updated annually.…”