Max Headroom: Discretionary Capital Buffers and Bank Risk

I posted my paper on SSRN. It examines the association between discretionary capital buffers, capital requirements, and risk for European banks. The discretionary buffers are banks’ own buffers, or headroom: the difference between reported and required capital. I exploit capital requirements data that banks started to disclose since the release of a 2015 European Banking Authority opinion. Using detailed SREP and Pillar 2 data of the largest 99 European banks over 2013-2019, I show that less headroom is associated with increased bank risk.

So, yes, headroom matters: banks with less capital over the requirements are riskier.

An additional examination reveals a positive association between headroom and stress test results for banks subjected to the Single Supervisory Mechanism, a result that runs against supervisory requirements.