“The Crooked Smile of TCR”: Banks’ Solvency and Restructuring Costs in the European Banking Industry

Abstract

In this study, we analyze the probability of bank failure, the expected losses, and the costs of bank restructuring with the application of a lognormal distribution probability function for three categories of European banks, that is, small, medium, and large, over the post-crisis period from 2012 to 2016. Our goal was to determine whether the total capital ratio (TCR) properly reflects banks’ solvency under stress conditions. We identified a phenomenon that one can call the “crooked smile of TCR”. Medium-sized banks with relatively high TCRs performed poorly in stress tests; however, the probability of bank failure increases slightly with the size of the bank, while the TCR decreases. We claim that the focus on capital adequacy measures is not sufficient to achieve the goal of improving banks’ stability and reducing their restructuring costs. Our results are of special importance for medium-sized banks, as these banks are not regularly subjected to publicly available stress tests.