In the years 2009 to 2013, many European banks repurchased debt that traded below par with the aim of increasing their Core Tier 1 capital ratio. In anticipation of the new capital requirements that would enter into force in 2014, banks repurchased these below par debt securities to realize the associated unrealized fair value gain.1 Bank regulation excludes unrealized fair value gains on debt securities arising from a deterioration in a bank’s own credit standing from the calculation of regulatory capital. Even if banks wanted to use the fair value option for liabilities, regulation prevented them from doing so for the calculation of capital ratios. Banks thus had an incentive to engage in Liability Management Exercises (LMEs), that is, buybacks of debt securities that trade below par, as it allowed them to turn the unrealized gain into a realized gain that increases regulatory capital. Using data of unprecedented detail, we examine the determinants of 720 European LMEs as well as their effects on solvency and liquidity. We also examine the determinants of the buyback premium as a measure of the inefficiency of an LME and the types of instruments that were bought back. In the years leading up to the implementation of Basel III in Europe (2009-2013), banks’ demand for equity capital increased significantly. Whereas under Basel II rules banks could satisfy an 8% capital requirement with 2% common equity over risk-weighted assets, under Basel III, the Common Equity Tier 1 (CET1) requirement can be as high as 14.5%. Many European banks could not satisfy these higher capital requirements at relatively short notice through conventional methods such as retaining profits, issuing shares, or selling assets with high risk weights: Bank profitability and investors’ willingness to buy banks shares have been low since the onset of the global financial crisis and European regulators banned banks from selling assets with high risk weights. In the absence of alternative viable means to increase capital, many European banks decided to repurchase debt that traded below par. These banks actively managed their liabilities to realize gains on liabilities that originated from a weak credit standing. To illustrate this, assume that a bank faces a deteriorated credit standing. This results in a potential gain on a debt security because increases in credit risk result in decreases in debt value. If the bank values the debt security at amortized cost, a repurchase at the lower market value turns the potential gain into a realized one. If the bank fair values the debt security, the bank will recognize an unrealized fair value gain when its credit standing deteriorates, that is, without having to buy back the security. This unrealized gain increases the bank’s equity level and its Core Tier 1 ratio. However, this is where the prudential rules come into play. Banks are subject to a prudential filter that requires them to exclude, from the calculation of regulatory capital ratios, any unrealized gains or losses on their liabilities valued at fair value that are due to changes in their own credit standing (e.g., see Article 64(4) of European Commission [EC], 2006). But, a bank can circumvent the prudential rules by repurchasing the debt security at the lower market value. This, of course, works well if the debt security is traded below par. The realized fair value gain is then included in the calculation of the Core Tier 1 ratio.