The prudential regulatory response to Covid-19: UK and EU regulators announce new measures

Last week the Bank of England (the “BoE”) announced a package of prudential measures designed to help UK businesses and households "bridge" the economic disruption that is already being experienced (and is expected to continue for some time) as a result of the Covid-19 outbreak. These measures, which are intended to help banks and building societies maintain the flow of credit into the wider economy, include: (i) a new Term Funding scheme with additional incentives for Small and Medium-sized Enterprises (“TFSME”); and (ii) a reduction in the UK countercyclical buffer to 0% and (iii) confirmation of supervisory guidance that capital and liquidity buffers can be used to address temporary shocks.

Similarly at the EU level, the European Banking Authority (the “EBA”), the European Central Bank (the “ECB”) and national competent authorities (“NCAs”) are coordinating efforts to alleviate the immediate market stress for banks from the outbreak of Covid-19, including measures such as relaxing inspections and reporting dates and forbearance of meeting capital buffers with non-CET1 capital.

UK – Bank of England and PRA

The measures announced by the BoE on 11 March 2020 included:

Reduction of Bank Rate and new term funding scheme

The Monetary Policy Committee (MPC) voted unanimously to:

  • reduce the Bank Rate to 0.1% (after an original reduction to 0.25%);
  • introduce the TFSME, financed by the issuance of central bank reserves;
  • maintain the stock of sterling non-financial investment-grade corporate bond purchases, financed by the issuance of central bank reserves, at £10 billion; and
  • maintain the stock of UK government bond purchases, financed by the issuance of central bank reserves, at £435 billion.

The TFSME is intended to help banks pass on the reduction in the Bank Rate to their customers. at this point, Conceptually similar to other BoE facilities, the TFSME will offer 4 year funding to participants on rates at or close to Bank Rate against the provision of eligible collateral (subject to haircuts) by those participants. Though the detail is sketchy, additional lending will be available for increased funding to the real economy, especially to Small and Medium-sized Enterprises.

The BoE expectation is that over the next 12 months the TFSME will offer funding of at least 5% of participants’ share of real economy lending. Its experience from the existing Term Funding Scheme (which ran from September 2016 to February 2018 and is closed to new drawings) suggests that the TFSME could provide in excess of £100 billion in term funding.

Countercyclical buffer reduced to 0%

The Financial Policy Committee (“FPC”) reduced the UK countercyclical capital buffer rate to 0% of banks’ exposures to UK borrowers with immediate effect for at least 12 months. The rate had been 1% and had been due to reach 2% by December 2020 to deal with transitional risks from Brexit. According to the BoE’s statement, the release of the countercyclical capital buffer will support up to £190 billion of bank lending to businesses. Any subsequent increase will not take effect until March 2022 at the earliest.

Regulatory Guidance

The FPC and the Prudential Regulation Committee (“PRC”) specifically noted expect that all elements of bank capital and liquidity buffers can be drawn down as necessary to support the economy through a temporary shock like Covid-19.

Consistent with this and the approach of its EU counterparts (see below), the Prudential Regulation Authority (the “PRA”) re-iterated a similar message in its announcement of 11 March 2020 confirming that the role of capital buffers is to absorb losses in times of stress such as the current conditions. It emphasised that (i) the use of the PRA Pillar 2 buffer or the CRD IV combined buffer is not a breach of capital requirements or the Threshold Conditions, (ii) the PRA buffer is confidential and the automatic distribution restrictions which apply to the CRD IV combined buffer do not apply to it and (iii) automatic restrictions resulting from use of the CRD IV combined buffer are a capital conservation measure.

On the other hand, regulators expect banks to take a sensible approach to current market conditions. So for example in the same paper, the PRA,  announced its supervisory expectation that banks should not increase dividends or other distributions, such as bonuses, in response to these policy actions being taken. It also expressed its expectations for senior managers with the responsibility of overseeing the development and implementation of each firm’s remuneration policies and practices.

Finally in response to the material fall in government bond yields in recent weeks, the PRC invites requests from insurance companies to use the flexibility in Solvency II regulations to recalculate the transitional measures that smooth the impact of market movements.

EBA

On 12 March 2020, the EBA issued a public statement on regulatory actions to mitigate the impact of COVID-19 on the EU banking sector. Pursuant to this statement the EBA 

  • has decided to postpone the EU-wide stress test exercise to 2021, in order to allow banks to focus on the continuity of their core operations and ongoing support for their customers;
  • recommends NCAs to plan supervisory activities, including on-site inspections, in a flexible way and postpone those deemed non-essential; and it also recommends NCAs to give banks some leeway in the remittance dates for some areas of supervisory reporting (to the extent possible for the continuing effective supervision of relevant firms);
  • encourages NCAs, where appropriate, to make full use of flexibility already embedded in the regulatory framework (e.g. measures similar to the ECB’s decision to allow significant banks to cover Pillar 2 requirements with capital instruments other than common equity tier 1 (CET1) – see next section below);
  • notes that the liquidity coverage ratio is designed to be used by banks under stress and NCAs should avoid any measures that may lead to the fragmentation of funding markets; and
  • notes that there is some flexibility in relation to the implementation of the EBA Guidelines on management of non-performing exposures and calls for a dialogue between supervisors and banks on their non-performing exposure strategies on a case by case basis.
ECB

On the same day (12 March 2020) and consistent with the EBA’s views, the ECB announced a number of measures to ensure that directly supervised banks under the Single Supervisory Mechanism can continue to fulfil their role in funding the real economy despite the economic effects of Covid-19.

  • The ECB will allow banks to operate temporarily below the level of capital defined by the Pillar 2 Guidance (P2G), the capital conservation buffer (CCB) and the liquidity coverage ratio (LCR). The ECB considers that these temporary measures will be enhanced by the appropriate relaxation of the countercyclical capital buffer (CCyB) by the national macroprudential authorities (see, for example, the BoE statement above).
  • Banks will also be allowed to use capital instruments that do not qualify as Common Equity Tier 1 (CET1) capital, for example Additional Tier 1 or Tier 2 instruments, to meet the part of the Pillar 2 Requirements (P2R). This brings forward a measure that was initially scheduled to come into effect in January 2021, as part of CRD V.
  • In addition, the ECB is discussing with banks individual measures, such as adjusting timetables, processes and deadlines. For example, the ECB will take a more flexible and pragmatic approach to onsite inspections and will consider extending deadlines for certain non-critical supervisory measures and data requests.
  • The ECB makes remarks similar to the EBA’s in relation to non-performing exposures. The ECB Guidance to banks on non-performing loans also provides supervisors with sufficient flexibility to adjust to bank-specific circumstances.

These actions follow a letter sent on 3 March 2020 to all significant banks to remind them of the critical need to consider and address the risk of a pandemic in their contingency strategies. Banks were asked to review their business continuity plans and consider what actions could be taken to enhance preparedness to minimise the potential adverse effects of the spread of Covid-19.

Germany – BaFin and Bundesbank

The German Federal Financial Supervisory Authority (BaFin) applies the measures and recommendations of the ECB and EBA in its supervision of the less significant institutions. In its general administrative act (only available in German) of 31 March 2020 BaFin has followed the ECB’s suggestion that national supervisory authorities reduce the countercyclical capital buffer by reducing such buffer (introduced last June) from 0.25% to 0% as of 1 April 2020, prior to its intended first implementation in July 2020. This follows the example of a number of other regulators (including, amongst others, the National Bank of Belgium and the Bank of England (“BoE”)).

Due to the challenges posed by the corona virus, the German Federal Bank (Deutsche Bundesbank) and BaFin also decided to postpone the stress test for Less Significant Institutions (LSIs) under national supervision from 2021 to 2022.

Furthermore, BaFin decided to discontinue on-site audits as part of the audit of the annual financial statements in accordance with sections 28 et seq. German Banking Act (Kreditwesengesetz – KWG) or the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) audit in accordance with section 89 WpHG. However, the institutions must generally ensure that the documents required for the audit can be made available to the auditors via electronic access. Violations of deadlines will not be pursued by BaFin. A formal interruption notification is not required. 

With regard to risk management BaFin and Deutsche Bundesbank published a letter (only available in German) to the credit institutions in which they provide information on crisis-related internal regulations and risk management in the trade area and for trading activities outside of business premises. As a matter of principle, the BaFin circular “Minimum Requirements for Risk Management” (MaRisk) stipulates that trading activities may only be carried out outside of business premises if the relevant circumstances have already been clearly regulated by the institution. However, if there is no possibility of access to the business and trading premises, the supervisory authorities consider it necessary to create an alternative in order to maintain business operations. Where institutions had previously excluded such trading activities, they must explicitly lift the ban and give clear work instructions under which conditions and for which period of time the new rules apply.