Tailored microprudential recommendations for bank profit retention using a risk tolerance framework

This study presents a tailored microprudential approach to profit retention by reversing bank failure prediction models within a risk tolerance framework. Using a dataset of approximately 700 European commercial banks from 2012 to 2022, including around 30 failed institutions identified by the European Banking Authority based on notifications of resolution cases and liquidations involving deposit guarantee funds, the research develops several early warning models. These models integrate macrofinancial stress indicators, bank-specific intermediation measures, financial control variables, and capital buffers. The aim is to align prudential expectations for dividend payout ratios with each bank's risk profile, derived from distress probability models. The results propose that banks' dividend policies should be adjusted based on their capital adequacy and failure likelihood, offering a dynamic and risk-based approach to profit retention. These insights are critical for policymakers, supervisors, and bank managers focused on maintaining financial stability and optimizing prudential buffers, while allowing for more flexible capital planning tailored to macroeconomic conditions. • Identifying the drivers of European commercial bank failures officially listed by the EBA. • Integrating regulated MIP indicators for economic surveillance into supervisory ratings. • Centering the supervisory approach to bank fragility on the concept of failure probability. • Calibrating supervisory expectations for profit retention by inverting bank failure models. • Establishing the supervisory risk tolerance limit based on the natural rate of bank defaults.