Economic Memos provide insight into the analysis work being performed by Danmarks Nationalbank’s employees. For example, Economic Memos contain background analyses and method descriptions. Economic Memos are primarily targeted at people who already have a knowledge of economic and financial analyses.
Banks’ use of AT1 capital and its determinants
Using data on a sample of European banks, we investigate what determines banks’ use of Additional Tier 1 (AT1) instruments in their capital structure. Banks’ capital structure can potentially influence their funding costs, especially during market stress. Banks’ capital structure might therefore be crucial in shaping bank behaviour during a crisis, such as whether they would continue lending or resort to shrinking their balance sheets to maintain a safe distance from regulatory requirements. This analysis suggests that banks with low capital headroom in particular use more AT1 – both to meet increases in capital requirements and during periods of market stress.
Key messages
Why is this important?
One important lesson from the global financial crisis was that banks needed both more loss-absorbing capital to fund their assets. Regulators introduced AT1 instruments as part of the Basel reform package to give banks greater flexibility in holding loss-absorbing capital.
Banks must comply with different requirements concerning both the size and composition of their capital and liabilities. While specific capital composition rules apply to risk-based capital requirements, banks have more leeway to decide the composition when it comes to the leverage ratio requirement. Banks’ choice of capital structure might have an impact on their funding costs, especially during market stress. The capital structure can thus be crucial for bank behaviour during a crisis, e.g. for whether a bank decides to continue lending or to shrink its balance sheets to maintain distance to regulatory requirements.
This memo seeks to address two key questions: What determines the amount of AT1 banks use to fulfil capital requirements? And how do banks adjust their AT1 holdings to changes in capital requirements? The analysis suggests that banks with low capital headroom make more use of AT1 compared to banks with high capital headroom – both to meet increased capital requirements and during periods of market stress.
Main chart
Banks with low capital headroom use more AT1 than banks with high capital headroom
Note:
‘Capital headroom’ refers to the distance between a bank’s capital ratio and capital requirements (including the combined buffer requirement). ‘High capital headroom’ refers to banks with capital headroom above the median, while ‘low capital headroom’ applies to those below the median. The lower quantile represents the 25th percentile, and the upper quantile represents the 75th percentile.
Source:
Own calculations based on data from EBA Transparency Exercise.