Systemic banks, capital composition, and CoCo bonds issuance: The effects on bank risk

• Author: Victor Echevarria‐Icaza,Simón Sosvilla‐Rivero
• Date: 01 April 2018
• DOI: http://doi.org/10.1002/ijfe.1607
• Published date: 01 April 2018

RESEARCH ARTICLE

Systemic banks, capital composition, and CoCo bonds

issuance: The effects on bank risk

Victor Echevarria‐Icaza | Simón Sosvilla‐Rivero

Complutense Institute for International

Studies, Universidad Complutense de

Madrid, Madrid 28223, Spain

Correspondence

Simón Sosvilla‐Rivero, Complutense

Institute for International Studies,

Universidad Complutense de Madrid,

Madrid 28223, Spain.

Email: sosvilla@ccee.ucm.es

Funding information

Spanish Ministry of Economy and Com-

petitiveness, Grant/Award Number:

ECO2016‐76203‐C2‐2‐P; Spanish Ministry

of Education, Culture and Sport, Grant/

Award Number: PRX16/00261; Bank of

Spain, Grant/Award Number: PR71/15‐

20229

JEL Classification: G12; G21; G28

Abstract

This paper shows that systemic banks are prone to increase their regulatory

capital ratio through a decline in risk‐weighted assets density and an intense

use of lower level capital. The market access of systemic banks and the fact that

they were singled out for higher capital requirements seem to have biased them

towards lower level capital, consistent with the theory that asymmetric infor-

mation drives capital decisions. These effects are particularly strong for institu-

tions that had a rather low level of capitalization at the start of the period and

for those that exhibited a strong use of additional Tier I capital before the reg-

ulatory changes. Strict capital composition requirements for firms with lower

buffers would be an improvement.

KEYWORDS

asset substitution,banking regulation, contingent capital, risk‐taking incentives, systemic risk

1|INTRODUCTION

This paper analyses the effect of regulatory capital

requirements for systemic banks on their capital struc-

ture. Since 2008, the regulation has tightened across all

banks, with the introduction of stricter capital require-

ments for financial institutions. This was based on the

idea that policymakers had that insufficient capital had

made firms vulnerable (see, e.g., Admati & Hellwig,

2014; Kashkari, 2016) and led to public bailouts.

One aspect of the regulation that was particularly

heeded was the effect of systemic banks. The failure of

these banks can have adverse effects on the overall finan-

cial system and spread on to the sovereign (see, e.g., Singh,

Gómez‐Puig, & Sosvilla‐Rivero, 2016).

1

As a result, they

benefit from an implicit protection by the sovereign. Regu-

lators have pushed regulation that improves the resiliency

of these financial institutions, increasing their capital

requirements (Hannoun, 2010) and thus lowering the

probability that they will be bailed out and the eventual

size of a bailout package (Calderon & Schaeck, 2016;

Duchin & Sosyura, 2014; Giannetti & Simonov, 2013).

We examine how systemic institutions have differed

from other institutions in their approach to strengthening

their equity ratios. Their approach may differ for several

reasons. First, capital regulation is stricter with systemic

institutions, in particular through the systemic surcharge,

which affects only the highest level of capital (Common

Equity Tier 1 [CET1]) and through certain requirements,

like the total loss‐absorbing capacity (TLAC) that pertain

to overall capital and loss absorbing liabilities. This may

lead banks to diversify their sources of capital. In particu-

lar, they may want to avoid further dilution of equity

holders and so increase the issuance of debt‐like capital.

This may stem from a willingness to reduce the pressure

on their return on equity (ROE).

Second, given the implicit bailout from authorities,

systemic institutions have a tendency to use debt‐like

instruments, in which they benefit from a subsidy (see

Acharya, Anginer, & Warburton, 2013; Haldane &

Received: 27 September 2017 Accepted: 13 December 2017

DOI: 10.1002/ijfe.1607

122 Copyright © 2018 John Wiley & Sons, Ltd. Int J Fin Econ. 2018;23:122–133.wileyonlinelibrary.com/journal/ijfe