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.
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).
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.