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Bank Capital – Why it matters

This briefing addresses the topic of capitalisation of financial institutions. Regulatory capital requirements ensure that financial institutions have robust capital levels and have helped place financial institutions in a strong position to approach the challenges presented by the Covid-19 pandemic. Banks have continued to play a key role in funding the real economy and regulators have helped to facilitate this by easing some of the regulatory capital rules and providing guidance. However, to ensure that they can continue to operate within the required regulatory capital framework, banks will need to continually assess the strength of their balance sheet and impact on their capital position which may, in turn, lead to a restriction on forms of lending and other activities.

Capital Requirements

After the financial crisis of 2008, the regulatory capital rules for financial institutions have been significantly revised by raising the quality, consistency and transparency of the capital base as well as increasing the capital ratios and imposing new capital buffer requirements.

The most relevant measure for the regulatory capital requirements is the (overall) Core Equity Tier 1 capital (“CET1”) ratio which, however, is not a capital requirement of its own but rather a “blended” ratio that incorporates different requirements. It is generally made up of four components: (i) Pillar 1 minimum requirement; (ii) Pillar 2 requirements (“P2R”); (iii) combined capital buffers; and (iv) Pillar 2 guidance (“P2G”). Of these four components only the P2G does not form a regulatory requirement but rather a recommendation by the regulator for the individual institution. P2R is also set to the individual institution as it aims to reflect the specific risk situation of the relevant institution. With regards to the composition of the P2R, CRDV brings a relief for institutions as it allows them to meet the P2R with Additional Tier 1 and Tier 2 instruments but 56.25% of it must still be formed by CET1. Although this relief was intended to be applicable as of January 2021, the European Central Bank (“ECB”) allowed banks to apply it earlier to ease the CET1 requirements in the face of the Covid-19 pandemic. Nevertheless, a CET1 shortfall can have different consequences ranging ultimately from distribution restrictions to licence withdrawal. Complying with the required CET1 ratio is a key element of the management of a financial institution. 

Capital requirements, however, do not only impose a legal requirement that needs to be maintained. They have an impact on the business activity and balance sheet management of financial institutions. The reason for this impact lies in the mechanism behind the calculation of the required amount of regulatory capital which is based on the exposure values of assets and off-balance sheet items and the risk-weighting applicable to such exposures. Therefore, regulatory capital requirements are determined by dynamic factors while the amount of CET1 capital available for the institution is rather static. This in turn can lead to a restriction of the financial institutions’ business activity where the amount of CET1 is limited. The interaction of dynamic and static factors not only explains why most banks operate at a level above the regulatory requirements but also why an active balance sheet management is so important. Whilst financial institutions can always raise new capital, this is dilutive and expensive and can be particularly challenging in stressed market conditions. 

It is therefore not surprising that many of the supervisory reliefs recently provided by regulators aimed to preserve the capital ratios of financial institutions. By that they reacted swiftly to the potential risks of the procyclical effects of regulatory capital requirements. These broad measures by regulators and lawmakers, together with the increased and strengthened capital levels which have been built up during the recent years, have meant that financial institutions have been able to continue to focus on their lending activities in the most critical phases of the economic downturn caused by the Covid-19 pandemic. The measures have also had to take into account the potential for future substantial borrower defaults once the longer-term impact of the Covid-19 pandemic is felt in the years to come. The following section considers some of these key measures in more detail, namely: (i) capital buffers; (ii) the leverage ratio; and (iii) the impact of IFRS 9 and the regulatory response to it.

Capital Buffers

Since the amount of an institution’s CET1 is not as dynamic as the development of the risk-weighted assets, it is important that the regulatory requirements allow some flexibility with regards to the capital levels that need to be maintained by institutions. This flexibility is achieved by the capital buffer requirements in the Basel III / Capital Requirements Regulation (“CRR”) framework, including the capital conservation buffer and the buffer for global systemically important banks (“G-SIB”). In addition, there is the counter-cyclical buffer which the competent authorities can impose on a nationwide basis to banks in a particular jurisdiction. The aim of the counter-cyclical buffer is to build it up during periods of economic strength and reduce it to zero when a recession is on the horizon, so providing additional capital coverage to banks. However, counter-cyclical buffers have been implemented by regulators rather cautiously. As an example, BaFin in Germany increased the counter-cyclical buffer from 0% to 0.25% in July 2019 but then reduced the buffer rate to zero in April 2020 to free up capital for the institutions. The ability to use these capital buffers allows institutions to absorb substantial credit losses, particularly in an economic downturn, while at the same time providing further funding to corporations and households.

Recent clarifications by the ECB and other competent regulators to allow banks to operate below the required level of capital buffers (that would normally have to be maintained to meet the individual institution’s capital requirements) increases the institutions’ loss absorption and lending capacity. As most of the financial institutions in the EU have a CET1 ratio substantially above the regulatory required minimum levels, the lending capacities should – from a holistic perspective – be sufficient to weather the immediate impact of the crisis.

However, the depletion of the capital buffers and the “management buffers”, i.e. the difference between the available capital of a bank and the capital requirements and buffers set by the supervisor, have to be monitored and managed carefully. Financial institutions not only need sufficient funding capacities to respond to short-term liquidity needs of their clients and to support the rebuilding of the economy, but also need to fund the rebuilding of their own business models. Further, operating above the required minimum is also important for the refinancing abilities of an individual institution as rating agencies consider the minimum requirements as a floor rather than an optimum. Another aspect that needs to be considered in the context of “using” capital buffers are potential constraints with regards to dividend and bonus payments. Although this is generally difficult during the current crisis given the expectations expressed by regulators and the public, the ability of an institution to operate during times of crisis above the minimum requirements should give them a strong “factual” argument to support discussions with the regulator in case such payments are envisaged. On the other hand, if an institution operates below the capital buffers described above it would have difficulties to return to dividend and bonus payments even during “normal” economic conditions.

Leverage Ratio

The leverage ratio (Art. 429 et seqq. CRR) constitutes an additional own funds regime for financial institutions. It is calculated by dividing the capital measure by the total exposure measure. In this regard, the capital measure equals the Tier 1 capital while the total exposure measure is made up of assets and off-balance sheet items. The key element of the leverage ratio is that it is not based on an assessment of risk or default and risk mitigants such as security and guarantees are generally not taken into account other than in very limited specific cases, such as cash variation margin in the context of derivative transactions. The non-risk-based nature of the leverage ratio is notable for its role as a backstop to the risk-weighted regime, in particular as regards banks that use their own internal models. The leverage ratio is therefore another instrument in the regulatory arsenal to mitigate the procyclicality of the risk-weighted rules.

Covid-19 highlighted that holding of central bank reserves can be expensive from a leverage perspective, despite the risk-free nature of the reserves. This problem occurs when an institution receives an increased inflow of funds such as deposits. This inflow usually leads to an increase of the bank reserve which is held at the institution’s respective central bank. As bank reserves constitute an asset on a bank’s balance sheet, they are included in the calculation of the leverage ratio. Thus, the increase in bank reserves could lead to a decrease of the leverage ratio, putting pressure on the bank’s lending capacity or other capital consuming business activities. Under the risk-weighted capital regime, the same flow of funds has no impact on the regulatory capital situation of the bank as central bank reserves are treated as risk free. This really illustrates the functional differences between the two regimes that set the framework for the regulatory capital levels of financial institutions.

The effects described above are not of a mere theoretical nature; in the United States, where the (supplemental) leverage ratio is binding on US financial institutions, reports and research indicate that the supplemental leverage ratio had a negative impact on the liquidity of usually very liquid markets like the treasury market during the market turmoil in March and April 2020.

Therefore, regulators and legislators introduced measures to avoid such developments in the near future. The European legislator, for example, amended Art. 429a CRR and introduced Art. 500b CRR to allow the exclusion of certain central bank exposures of institutions from the total exposure measure. For banks in the EU this will especially be of relevance after the leverage ratio requirements of Art. 92 (1) lit. d CRR become applicable on 28 June 2021. 

IFRS 9

As capital ratios depend highly on the applicable accounting frameworks, the impact of the new accounting standard IFRS 9 on the capital situation of financial institutions is important. Although IFRS 9 is generally considered to be a prudent accounting approach to avoid the “too late and too little” criticism raised in respect of the accounting approaches during the Financial crisis of 2008, it poses a challenge for banks in times of sudden and wide-spread economic stress. The risk for financial institutions as well as the real economy lies in the fact that, by strictly adhering to the requirements of IFRS 9, institutions would have to realise significant short-term losses on their balance sheets which would deplete their regulatory capital and limit or even block their ability to provide funding to corporates and households.

It is therefore not surprising that many of the supervisory reliefs provided during recent months dealt with the implications of IFRS 9 on bank capital. As an example, the ECB communicated that it expects banks to give a greater weight to long-term macroeconomic forecasts evidenced by historical information when estimating expected losses within the framework provided by the accounting standards. Another measure was the amendment of Art. 473a CRR which governs the introduction of IFRS 9 and contains several transitional measures. One of its core features is the so- Called “add-back” to CET1 capital. The add-back allows institutions to include expected credit loss (“ECL”) amounts, as calculated subject to Art. 473a CRR, to be included in – i.e. “added back” – the CET1 capital for a transitional period of five years (2018 to 2022). However, as not all institutions have opted to use this transitional measure, the amendment of Art. 473a CRR now allows them to reverse this decision subject to prior approval from their competent authority (for more coverage on IFRS 9 see our briefing: “Asset Quality and NPEs”).

Summary

The regulatory capital framework has ensured that the financial institutions have strong capital bases to withstand the pressure of the current crisis. On the other hand, it does also mean that banks will, in practice, be limited from undertaking some activity (including some forms of lending) where they don’t have sufficient capital to do so. Alternatively, they may seek to de-leverage to reduce the amount of risk on their balance sheets.
But despite these factual limiting effects, the recent months have also shown that the relevant framework contains “built in” flexibility, like capital buffers, which helps to mitigate the procyclical effects. By clarifying that such flexibilities should be used wherever possible and prudent, regulators have helped financial institutions to respond to the short-term needs of companies and households. Further, regulators and legislators have also taken immediate legislative action to – at least temporarily – provide relief in respect of capital requirements where procyclical effects were suspected or appeared during the first days of the Covid-19 crisis.

Going forward, one of the most critical decisions of regulators with an immense impact on financial institutions will be to determine the timing for the withdrawal of the relief measures. The ECB gives an indication of how serious a premature return to the “full” capital requirements is considered, even by supervisors. In its “FAQs on ECB supervisory measures in reaction to the coronavirus” the ECB states that it does not expect institutions to operate above the level of their P2G any sooner than the end of 2022. This also indicates that the ECB considers roughly the next 24 months as a time of increased pressure on bank capital.

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