Maintaining adequate bank capital: An empirical analysis of the supervision of European banks

During the recent financial crisis, many large banks' losses were absorbed by their sponsoring governments, despite the fact that these banks complied with Basel standards for “adequate” capital. We illustrate a serious supervisory problem by demonstrating that large European banks' reported regulatory capital measures often far exceeded their loss-absorbing capacity during 1997-2011. The cumulative value of government guarantees thereby extended to the largest 25 European banks over that period amounts to nearly €1.4 trillion, corresponding to an average of 28.5% of the banks' equity market values. We show that early regulatory attention to declining equity value can substantially reduce the social cost of dealing with bank losses. This research is particularly relevant for European institutions at the present time, as the European Union deals with joint solvency concerns about its banks and its governments.