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The new capital stack confirmed

The new capital stack confirmed

Last year we wrote about the hidden significance of the EBA's decision to modify its SREP guidelines on the double counting of Common Equity Tier 1 (CET1) capital. Fast forward to 2019 and it's now clear that the ECB will adopt this new approach from next year. That will have an impact on the stacking order of capital, and could drive up some banks' effective CET1 demand by as much as 150 bps in 2020.

Back in 2018 the EBA published revised SREP guidelines stating that banks' own funds held under Pillar II Guidance (P2G) would no longer be eligible to meet any other regulatory requirement. In particular, funds covering P2G cannot be used to make up any shortfall in Additional Tier 1 (AT1), Tier 2 (T2), the Pillar II Requirement (P2R) or the Combined Buffer Requirements (CBR).

The ECB finally confirmed, in its recently published version of the SSM's SREP methodology booklet (PDF 1.62 MB) , that it will align its approach with the EBA's guidelines from 2020 onwards.

This news means that banks have less than a year to prepare for the first major change to the stacking order of regulatory capital since 2016. The elimination of double counting could drive a significant increase in some institutions' effective CET1 requirements. In theory, that uplift could be equivalent to as much as 1.5% of risk-weighted assets.

As a reminder, the forthcoming changes can be summarised as follows.

  • At present, a bank's effective CET1 requirement is equivalent to its OCR OCR = Overall Capital Requirement. The OCR comprises the Total SREP Capital Requirement (Pillar 1 and Pillar 2 Requirement) plus Combined Buffer Requirements (capital conservation buffer, countercyclical buffer and systemic buffers), plus the bank's P2G or any shortfall in issued AT1/T2 - whichever is the greater. So CET1 held by banks to meet their P2R can also be counted towards P2G.
  • From 2020 onwards, the CET1 requirement will constitute the OCR plus the P2G as well as any shortfall in AT1/T2 (see Figure 1). In other words, CET1 (minimum own funds requirements) held against P2G cannot be used to cover any shortfall of other regulatory requirements.

Figure 1: Capital stack

Pillar to guidance figure

Note: scale not meaningful

To consider a hypothetical example, imagine a bank with an OCR of 9%, Pillar II Guidance of 100 bps and no issued AT1 (hence, with an AT1 shortfall of 150 bps).

  • Under current SREP practice, the bank's CET1 requirement is effectively 10.5% (i.e. the OCR of 9% including the AT1 shortfall of 1.5%)
  • From 2020, the bank would face an effective CET1 requirement of 11.5% (i.e. the OCR of 9%, including the AT1 shortfall of 1.5%, plus the P2G of 1%).

With this in mind it's worth noting the latest EBA data, which suggests that several reporting banks - representing around 50% of the SSM's below average capitalised banks - still had some degree of AT1 shortfall at the end of the first half of 2018, of which around 80% have a considerable shortfall of 50 bps or more. Furthermore, some of those banks have limited experience of issuing convertibles or hybrid capital.

In summary, a minority of SSM banks could face a significant capital requirement impact in 2020. In our view, banks that have not already done so should act fast to review their funding mix. If required, they must begin building up their levels of AT1/T2 capital at the earliest opportunity.

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