Stock repurchases, ESG ratings and systemic risk in banking

Gehrig, Thomas Article Stock repurchases, ESG ratings and systemic risk in banking Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung (VAW) Provided in Cooperation with: Institut Arbeit und Wirtschaft (IAW), Universität Bremen / Arbeitnehmerkammer Bremen Suggested Citation: Gehrig, Thomas (2024) : Stock repurchases, ESG ratings and systemic risk in banking, Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung (VAW), ISSN 2942-1470, Duncker & Humblot, Berlin, Vol. 1, Iss. 2, pp. 207-223, https://doi.org/10.3790/vaw.2024.1447204 This Version is available at: https://hdl.handle.net/10419/317883 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Duncker & Humblot · Berlin Stock Repurchases, ESG Ratings and Systemic Risk in Banking By Thomas Gehrig* Summary Stock repurchases of banks have become an increasingly popular instrument of banks’ payout policies after the Great Financial Crisis. Recent empirical evidence documents that stock repurchases are particularly popular among global systemically important banks that tolerate relatively high levels of exposure to systemic risk. Hence, stock repurchases add to reducing risk-bearing capital precisely for those banks that have the greatest capital shortfall. The allow to secure short-term gains at the cost of long-run stability. This thematic review of the empirical literature finds that various ESG-ratings are indeed informative about the true underlying intentions and planning horizons of bank business models. ESG-ratings are informative both, about idiosyncratic as well as systemic risk, and, hence, implicitly also about bank resiliency. While regulators generally are not in the business to save individual firms, in the banking industry, however, their mission is to maintain the stability of the financial sector as a whole. This implies to ensure that systemic risk remains within socially acceptable bounds. Especially the exposure to systemic risk as proxied by capital shortfall requires a sufficiently high level of bank capital. Accordingly, one strong recommendation emerges from this survey of the relevant empirical literature: Since ESG-scores are particularly informative about the planning horizon of the underlying firms or banks, permission to repurchase stock should be granted particularly to those banks with higher ESG scores. Granting permission also to banks with lower ESG-scores increases bail-out risk for the tax payer, as experienced recently in the case of Credit Suisse. Zusammenfassung Seit der globalen Finanzkrise sind Aktienrückkäufe eine zunehmend beliebte Methode der Rückzahlung von Erträgen an die Eigentümer von Banken geworden. Insbesondere systemrelevante Banken nutzen Aktienrückkäufe, womit sie implizit risikobehaftetes Eigenkapital reduzieren und Insolvenzrisiken erhöhen. Während Aktienrückkäufe kurzfristige Aktionärsrenditen erhöhen, reduzieren sie andererseits langfristig die Widerstands- * Thomas Gehrig, University of Vienna, CEPR, ECGI, SRC, and VGSF, Department of Finance Austria, email: thomas.g[email protected]t This review is based on joint research with Maria Chiara Iannino and Stefan Unger. Helpful comments of Hans-Peter Burghof and an anonymous reviewer are gratefully acknowledged. Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung 1 (2024) 2: 207 – 223 https://doi.org/10.3790/vaw.2024.1447204 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2024.1447204 | Generated on 2025-05-19 12:46:55 208 Thomas Gehrig Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 1 (2024) 2 fähigkeit und Nachhaltigkeit der Bank. Im Falle von systemrelevanten Banken überträgt sich das Insolvenzrisiko einer Bank schnell auf das gesamte Bankensystem. Mittlerweile wird Nachhaltigkeit mit sog. ESG-Kriterien gemessen. Mit solchen Kriterien könnte somit die grundsätzliche Frage beantwortet werden, inwieweit Aktienrückkäufe destabilisierend wirken, sowohl für die einzelne Bank als auch für das Bankensystem insgesamt. Dieser Übersichtsartikel bietet einen Überblick über die ersten aktuellen empirischen Befunde zur Beziehung zwischen Nachhaltigkeit und Risiko. Hierzu werden Studien vorgestellt, die konkret den Zusammenhang zwischen ESG-Maßen und bankspezifischen Risikomaßen analysieren, wobei der Zusammenhang zwischen ESG-Kriterien und dem systemischen Ausfallrisiko (SRISK) im Mittelpunkt der Analyse steht. Implizit stellt sich die Frage, inwiefern die Bankenaufsicht aus ESG-Maßen Informationen über die zugrundeliegenden Geschäftsmodelle der Banken entnehmen können, die eine Genehmigung von Aktienrückkäufen entweder nahelegen oder eher davor warnen. Nach aktuellem Stand der Literatur können ESG-Kriterien spezifischer Anbieter solcher Informationen tatsächlich informativ über den effektiven Planungshorizont von Banken sein. Sie können daher grundsätzlich zu Zwecken der Bankenaufsicht zurate gezogen werden. Im Falle von Banken mit niedrigen ESG-Werten sollte die Bankenaufsicht besondere Vorsicht in der Genehmigung von Aktienrückkäufen walten lassen. Voraussetzung des Einsatzes von ESG-Innformationen ist natürlich eine sorgfältige Überprüfung des Informationswertes der spezifischen ESG-Maße mit Hinblick auf idiosynkratische Bankenund insbesondere auch Systemrisiken. JEL classification: E63, G21, G28, H25 Keywords: ESG ratings, stock repurchases, sustainability, resilience, systemic risk 1. Introduction Stock repurchases have become a favorite payout policy of banks. Notably in the run-up to the Great Financial Crisis (GFC) in 2007/8 stock repurchases served as a popular instrument to enhance return on equity and guarantee return on equity of 25 %.1 Surprisingly, despite the deep crisis experiences stock repurchases did not loose in terms of popularity among bankers. Rather stock repurchases are widely seen as reflecting intrinsic strength (e. g. Manconi etal., 2018). In the case of the banking industry, however, such a view is surprising given the extreme leverage of banks. Since the GFC capital shortfall has emerged as a major source of systemic risk for the whole banking sector. Moreover, it has proven notoriously difficult to recapitalize banks after the crisis without stringent regulatory pressure. Despite all the post-crisis regulatory reforms and adjustments to bank business models in March 2023 another wave of major banking failures occurred 2023 in the US (Silicon Valley Bank, Signature Bank, First Republic Bank) as well as in Europe (Credit Suisse). This recent evidence seems to lend support to the critical view that stock repurchases tend to secure short1 See Gehrig (2013 and 2015). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2024.1447204 | Generated on 2025-05-19 12:46:55 Stock Repurchases, ESG Ratings and Systemic Risk in Banking 209 Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 1 (2024) 2 term gains at the cost of long-run value (e. g. Fried, Wang, 2019, Lazonick, 2018). This raises questions about the resilience of the banking sector at large (see Admati, Hellwig, 2024, Buyl etal., 2022). Has banking become more fragile in general, or did specific business models of particular banks have turned too risky? If so, what are the drivers? Are there ways of identifying socially excessively risky business models2 with an eye of separating them from more resilient ones? In particular, given the modern focus on social responsibility, how informative are sustainability ratings, so-called ESG-ratings3 in this regard? Are socially responsible firms less tolerant with regard to systemic risk? If so, how does it affect stock repurchases and what is the contribution of stock repurchases to systemic risk? The measurement of social responsibility or sustainability is increasingly standardized. The early development of global reporting standards by the Global Reporting Initiative (GRI) has been transformed into legislation such as the EU—Corporate Sustainability Reporting Directive (CSRD), effective since January 2003. Essentially this process of standardizing sustainability measures comprise an E-pillar on environmental and economic concerns, an S-pillar on the social dimension and a G-pillar on governance policies. Each pillar again comprises sets of subcategories that are aggregated within that particular pillar. All together are aggregated into one overall ESG-score. Since most of the subcategories are of a qualitative nature, naturally the question arises about their informational content. Moreover, in order to avoid misleading frames the process of harmonization and standardization of sustainability reporting seems necessary (e. g. European Commission, 2023). The role of share repurchases is typically not addressed in the literature on sustainability. Nevertheless, the literature on the relation between ESG scores and the riskiness of the underlying business models has direct relevance for banks resiliency. Therefore, the purpose of this paper is to bring together these strands of literature and highlight the role of share repurchases for bank resiliency. Unlike the standard ESG screens share repurchases do not exert a moderating role, neither on general business risk as measured by proxies of systematic risk, nor on the leading measures of systemic risk such as exposure risk and contribution risk. The paper is organized as follows. Section2 provides a short overview over the evolution of various risk measures. It emerges that capital shortfall is trend2 See Gehrig (1997) for an early model of excessive risk in banking in a model of spatial com-petition and free entry and Gehrig (1998) for the heightened risk of cross‐border banking. 3 ESG is an acronym summarizing E = environment, S = social and G = governance. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2024.1447204 | Generated on 2025-05-19 12:46:55 210 Thomas Gehrig Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 1 (2024) 2 ing upwards over time especially for systemically important banks. Since especially those banks in profitable years are regularly given consent to repurchase their own shares on the stock market, Section3 provides empirical evidence for this market regularity. Section 4 provides a survey on the nascent literature about the relation between ESG scores and bank risk. It appears that ESG scores proxy for unobserved bank planning horizon. Accordingly, ESG activities play a moderating role on systemic as well as systematic risk in the banking sector. Section 5 presents policy advice derived from the evidence presented in this work and Section6 concludes. 2. The Evolution of Systemic Risk in Banking While systemic risk intuitively is related to the riskiness of the banking sector at large, it is less clear, how to precisely define and measure it. Not surprisingly, the number of potential economic rationales for systemic risk is mushrooming, and so is the number of systemic risk measures (see Giglio etal. 2016). For the empirical analysis of banking systems, however, two dominant concepts seem to emerge, the risk of repayment problems of one bank spilling over to other banks, associated with contribution risk, and the risk of becoming infected by spill overs from repayment problems of other banks, exposure risk. Measures of contribution risk are closely related to the concept of ΔCoVaR introduced by Adrian and Brunnermeier (2016). This purely market based systemic risk measure assesses the spillovers of distress from a given bank to the financial system. Hence, it measures the contagion deriving from a bank being in distress to the whole banking system. In empirical work, this systemic risk measure is closely related to periods of banking stress. Over time this measure behaves in a rather stationary way with relatively little variation in the cross section across banks (e. g. Gehrig, Iannino, 2021, see box). They use a quantile regression approach. The distress event of firmi is proxied by an equity loss equal to (1 – α) % of its VaR, such that rit = VaRit α. CoVaR represents the maximum loss of the market return within the α-confidence interval, conditionally on some event C(rit) observed for bank i: Pr(rmt ≤ CoVaRm|C(rit)) = α. With this ΔCoVaR of the banki is defined as the difference between the CoVaR of the financial system conditional on firmi being in distress and the CoVaR of the financial system conditional on firmi being in its median state, weighted by the bank’s market capitalization: ∆CoVaRit (α) = –(CoVaRm|C(rit)) = VaRit (α) – CoVaRm|C(rit) = Median(rit) ✳ MV where MV denotes market value. In line with the authors, ΔCoVaR is transformed in order to only generate positive values. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2024.1447204 | Generated on 2025-05-19 12:46:55 Stock Repurchases, ESG Ratings and Systemic Risk in Banking 211 Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 1 (2024) 2 Measures of exposure to systemic risk are variants of measures of capital shortfall. The most widely used exposure measure is the SRISK-measure introduced by Brownlees and Engle (2017). It provides a data-based estimate of the cost of immediate recapitalization of a bank by issuing stocks on the market in order to render them compliant with capital regulation after a major shock comparable to the GFC.4 It can be interpreted as measuring the likelihood of an individual banki of getting infected by shocks from other banks. Hence, it can be interpreted as an infection measure. More specifically, SRISK for banki in period t can be estimated as: SRISKit = Et–1[capital shortfalli | crisis] = Et–1[k(Debtit)– (1–k)(1–LRMESit )Equityit] where k is the prudential capital ratio, that we assume at 8 % (Engle, 2002); LRMESit = 1 – exp(ln(1 – d) beta) is the expected loss in equity value of banki, if the market were to fall by more than a d = 40 % threshold within the next sixmonths (according to V-lab documentation), and the market beta is a dynamic correlation coefficient between the bank’s and the market returns (Engle, 2002). SRISK is estimated daily and then aggregated annually. In their analysis of whether the Basel process of capital regulation has made European banks more resilient, Gehrig and Iannino (2018) and Gehrig, Iannino (2021) find that the exposure risk has turned into the major source of concern. While trajectories of contribution risk essentially remain stationary in the period of analysis from 1988 – 20185 exposure risk as measured by SRISK increases in the run-up to the GFC in the highest size quintile of bank and remains elevated at levels higher than in 2006 for that quintile. In contrast, Figure1 illustrates that the lowest three quintile of exposure risk remain stationary. Most interestingly systematic risk has been declining for the smaller and systemically less important banks relative to those imposing the highest exposure risk6. Systematic risk of the most systemically important banks has essentially remained constant for the observation period from 1988 – 2018.7 This suggests that exposure risk of European banks has not been growing due to heightened 4 While the strategy of immediate recapitalization is not an optimal response, this market‐based estimate allows to assess the market value of the lack of capital as the bank enters the brink of insolvency. This number is comparable across banks and can be traced across time. 5 https://vlab.stern.nyu.edu/docs/srisk/MES. 6 See especially Figure5 of Gehrig, Iannino, 2021. 7 Gehrig, Iannino (2021) find that the process of capital regulation has even been successful in reducing systematic risk of the smaller banks, while tolerating significant increases in capital shortfall, our measure of exposure risk, for the larger banks. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2024.1447204 | Generated on 2025-05-19 12:46:55 212 Thomas Gehrig Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 1 (2024) 2 business risk but rather due to regulatory policy or the use of internal credit risk models after 2006. Moreover, in transatlantic comparisons, banking systems in US and Europe differ mainly in their risk exposure and to a much lesser extent in their contribution risk. Even when controlling for different accounting procedures Gehrig etal. (2024a and 2024b) document significantly larger capital shortfall for European banks relative to their US competitors.8 3. Stock Repurchases in Banking Post GFC stock repurchases have turned into a favorite payout instrument of the banking sector (Hirtle, Zebar, 2023). They had already been important before and during the GFC (Hirtle, 2016) but their relative weight as an instrument of the policy has definitely increased in the US as well as in Europe post GFC (see Figure2 for the US). 8 At first sight the evidence of Bostandzic and Weiss (2018) seems to contradict this finding, but their samples are highly unbalanced. 6 Accordingly, average relative capital shortfall has increased continuously until the Great Financial Crisis and has been reduced barely to pre-crisis levels of 2006. How does this relate to the original intentions the BCBS? Moreover, has capital shortfall affected all banks alike, or do we observe differences in the cross-section? In order to address this queswe analyze the quintiles of the SRISK distribution. Rebalancing every year, we divide the financial institutions into 5 groups of positive relative exposure to SRISK, and we follow the evolution of the average capital shortfall. It turns out that it is essentially the upper two quintiles cause most of the increase in shortfall, while the risk exposure for the majority of banks has increased only slightly until 2018 (Fig. 3 any case the trajectories do not seem to reflect a long term increase resiliency. It is interesting to note that the introduction of internal market risk models in 1996 seems to have exerted a short-lived, discernible, moderating effect on the SRISK-trajectories across quintiles. 3.2.2. Delta CoVaR The contribution to systemic risk can be measured by Delta CoVaR, as developed by Adrian and Brunnermeier (2016). This is a purely market-based systemic risk measure, and, in contrast to SRISK, 2. Evolution of exposure to systemic risk - average SRISK relative to annual country GDP. The Figure tracks the daily total SRISK, as the sum of the normalized expected capital shortfalls across banks. SRISK is estimated as Equation 3 and only the positive side of the distribution is considered (capital shortfall). Positive SRISK normalized by annual country GDP. 3. Quantile effects and non-linearities. The figure reports the evolution of the daily average estimated SRISK (Equation 3), distinguishing five equal-size quintiles of relative capital shortfall (SRISK%), as in Equation 4, rebalanced annually. The top quintile (5-high) corresponds to the group of banks with the highlevel of positive SRISK, while the bottom quintile (1-low) corresponds to the group of banks with the lowest level of capital shortfall. Figure 1: SRISK Quintiles: Trajectories of the estimated daily SRISK averaged across the quintiles. The quintiles are rebalanced annually. The top quintile consists of banks with highest level of positive SRISK, while the bottom quintile is corresponds to the group of banks with the lowest level of capital shortfall Source: Gehrig, Iannino (2021). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2024.1447204 | Generated on 2025-05-19 12:46:55 Stock Repurchases, ESG Ratings and Systemic Risk in Banking 213 Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 1 (2024) 2 As documented already in earlier work (Hirtle, 2004) banks attempt to smooth payout via dividends while delegating the cyclical component of overall payout or crisis returns to stock repurchases. As such repurchases were completely phased out during the pandemic and largely reduced after the start of the Russian war against Ukraine. 2023 again has become a very profitable year for banks with record repurchasing programs being granted by the regulators on both sides of the Atlantic. In light of the documented increase in exposure to systemic risk this recent development is potentially troublesome. Stock repurchases are just the opposite of recapitalization. This matters especially in challenging times when equity buffers are low. Hence, in the run-up to the GFC some bankers publicly boasted to consistently maintain high returns to equity against all market difficulties.9 Return to equity has been—and still is—a favored performance measure of CEOs despite—or because of—the well-known defect that it can easily be manipulated by repurchasing stock. Since this “manipulation” is in the interest of incumbent stock holders they are unlikely to veto stock repurchase plans. Ultimately, only supervisors can stop banks from excessively conducting stock repurchases. 9 One prominent example is the CEO of Deutsche Bank who consistently insisted on a return on equity target of 25 % (e. g. NZZ, 2012). bank holding companies with data available since 2012. Net Income and Shareholder Payouts Twenty-one Large Bank Holding Companies, 2012:Q1-2022:Q3 Aggregate net income (the blue line in the chart) increased steadily for these banks in the years preceding the COVID-19 pandemic. (The sharp drop in net income at the end of 2017 reflects an accounting change that caused many banks to recognize one-time losses related to their deferred tax assets.) Shareholder payouts (the red line) also increased over these years, though at faster pace than net income. In 2012, shareholder payouts were significantly less than net income, meaning that these banks were accumulating capital via retained earnings. But by the second half of 2018 Figure 2: Dividends and Share Repurchases of Twenty-One Large Bank Holding Companies, 2012Q1 – 2022Q3 Source: Hirtle, Zebar (2023). OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/vaw.2024.1447204 | Generated on 2025-05-19 12:46:55 214 Thomas Gehrig Vierteljahreshefte zur Arbeitsund Wirtschaftsforschung, 1 (2024) 2 One implication of the ratchet effect is that banks are unlikely to voluntarily recapitalize by issuing new equity. In fact, the whole US banking system was recapitalized during the GFC by public intervention. In contrast, in Europe the public sector only intervened in failed banks such as the UBS in Switzerland. The unwillingness of banks to voluntarily recapitalize in periods of subdued market valuations is perfectly consistent with the interests of incumbent shareholders as dubbed the leverage ratchet effect (Admati etal. 2021).10 This effect claims that incumbent shareholders prefer to avoid dilution of their shareholdings. This interest is amplified for bank investors when general tax advantages on leverage of the non-financial sector are also applied to the banking industry.11 While after the GFC US banks had been recapitalized by law, European banks were not. The forced recapitalization helped US banks to overcome the leverage ratchet effect and, thus, to regain competitive positions in global markets. In contrast, the largest European banks never regained back their dominant positions of the early millennium. In fact, since the GFC most of the European globally systemically important banks (GSIBs) have been trading at values well below book values (Ferretti etal. 2018, ECB, 2019), while tolerating higher capital short fall relative to the pre-crisis period (Gehrig, 2023). This phenomenon is illustrated in Figure3. The evidence suggests that the European banking system was not able to rebuild trust lost in the GFC (see Lins etal. 2017, Fungacova etal. 2019 and Gehrig, 2013, 2015, 2024a). Even the harmonization of banking supervision in Europe by creating a European Banking Union in 2014 did not significantly contribute to rebuilding market trust and, hence, global competitiveness. The European evidence contrasts sharply to the evidence of the US. One main argument in favor of stock repurchases lies in the undervaluation of stocks in the market relative to the underlying intrinsic value (Manconi etal, 2018). Interestingly, however, the transatlantic empirical evidence seems to suggest, that repurchases are a regular phenomenon of the banking industry independently on whether stocks trade above or below book value. Moreover, the pattern of overor underpricing seems to be persistent over time. Therefore, a more likely explanation is tied to debt bias (Gehrig, 2023), which tends to incentivize banks to return capital in excess of the regulatory minimum rather than building large prudential buffers for reserve. 10 In fact, John Cryan, the CEO who had successfully managed the turn‐around of UBS has been dismissed after only one year of tenure at the helm of Deutsche Bank after attempting to realize the entrusted mandate to increase the bank resiliency by issuing new stocks on the market at a time when market valuations were significantly below book values. 11 For a discussion of how bank resiliency could be enhanced by eliminating the tax advantage on bank leverage see Schepens (2016) and Gehrig (2023). 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