Beyond Common Equity: The Influence of Secondary Capital on Bank Insolvency Risk

Abstract

Banks must adhere to strict rules regarding the quantity of regulatory capital held but have some flexibility as to its composition. In this paper, we examine if bank insolvency (distance to default) is sensitive to capital other than common equity for a sample of listed North American and European banks. Decomposing tier 1 capital into tangible equity and non-core components reveals a series of heretofore unidentified non-linear links with insolvency risk. We assess the influence of binding capital requirements, finding that low regulatory capital buffers are associated with increased insolvency risk for banks holding greater quantities of non-core tier 1 and tier 2 capital. The links between insolvency and capital, evident when the latter is denominated relative to tangible assets or total regulatory capital, are found to be expunged when defined relative to risk-weighted assets.