Banks in Europe are becoming pretty innovative in their efforts to boost profits and increase capital before the new Basel III regulations take effect. They are buying back their own bonds.
They can buy their own debt from investors at a discount, legitimately booking the difference in price as a gain on their balance sheets. This beefs up the banks’ bottom line and enhances their ability to weather losses.
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Selling off businesses or business units and raising equity in the markets are two more traditional ways of boosting capital but both of those methods have become much more challenging in light of the current economic environment in Europe.
Many European banks are suffering from lack of investor confidence, which makes it difficult to raise money. Analysts are taking issue with the debt buyback move, saying it could make banks more vulnerable in the long term.
That’s because it cuts off avenues of low-cost, long-term funding they may need down the road. That, in turn, would make low-cost aid from the European Central Bank (ECB) that much more attractive.
The buyback move is right in sync with typical European action of late, the quick fix answer to long-term capital issues. With risk levels so high, investors are no longer willing to buy longer maturities, squelching banks’ ability to issue the kind of debt that would buy them enough time to recapitalize themselves by more traditional means.
The buybacks are boosting banks’ Tier 1 capital ratios, a core measure that would satisfy the Basel III increased capital requirements. Some banks have even been able to double or triple the gains they book from the buybacks.
In these cases, they book the gains from the discount, gains from no longer having to pay the coupon, and the new equity issued to the investors. The banks say the buybacks have not affected their ability to go back into the marketplace and issue more debt later.
There is no doubt that the buybacks cut off a private source of current funding
and that automatically brings banks closer in line for funds from the ECB. And if recollections are correct, that’s exactly what the Basel III requirements are supposed to prevent. Since the Basel III requirements have also been adopted across the board for US banks, what does that mean for our own financial system’s future?