Are we seeing the early signs of a change in banking capital regulation?
Analyst, Global Financials Team
‘Complex’ has long been the most diplomatic word to describe the regulatory capital framework of banks. Despite starting off, after the global financial crisis, with a clear idea that banks should never again require significant taxpayer-funded capital injections, regulators have transformed the framework into an alphabet soup of micro and macro-prudential acronyms, with each requirement bolted on to the previous (see chart).
This could, however, all be about to change.
Cognisant of the stigma for banks associated with dipping into their capital buffers, as highlighted during the pandemic, the European Central Bank (ECB) recently suggested a series of amendments to the current framework. These included the possible merger of the conservation, systemic and countercyclical buffers as well as alterations to Additional Tier 1 securities (AT1s), with the removal of automatic conversion triggers and call optionality.
Hot on the heels of these suggestions was a speech by the Deputy Governor of Prudential Regulation at the Bank of England (BoE), and CEO of the Prudential Regulatory Authority (PRA), Sam Woods. In an entertaining paper, which includes references to actuaries as cool druids, he introduces the idea of a radically new capital framework – the ‘Basel Bufferati’.
This framework says goodbye to the complexity of Pillar 2 buffers, capital conservation buffers, countercyclical buffers, systemic buffers, Minimum Distributable Amount (MDA) restrictions and even AT1s. Instead, it welcomes a simple framework based on a single, releasable buffer of common equity sitting above a low minimum requirement.
It would be calibrated to reflect both micro (ie firm-specific) and macro-prudential risks, but with the average sitting within a ‘macroeconomically’ optimal range – ie if the macro-analysis suggested an average capital level of 14%, the range for low and high risk banks could be between 12% and 16%.
The focus on simplification is without doubt a positive; not only could it enable more generalists to engage with the sector, but also reduce the overall cost of equity.
Such radical changes are likely to take time to be enacted and, as Woods noted in his speech, require “clear international” agreement. Nevertheless, the focus on simplification is without doubt a positive; not only could it enable more generalists to engage with the sector, but also reduce the overall cost of equity.
It is important, however, to recognise that any changes should not be seen as throwing out the baby with the bathwater, but rather to maintain the strength of the sector. From this perspective, we take comfort that the regulator has “no interest whatsoever in designing a weak” framework and remains “fully committed to maintaining robust prudential standards”.
With the BoE’s focus on common equity and the ECB’s proposed alterations, the latest statements raise questions about the ongoing structure and need for AT1s. Any changes, such as the introduction of higher conversion trigger points, could result in the capital ineligibility of the current AT1 cohort. This could in turn easily result in spread tightening as their required replacement with newer compliant instruments would all but remove fears about extension risk.
In recent years, we1 have successfully made money from investing in several legacy capital trades, so-called because these instruments were no longer considered eligible as regulatory capital status following amendments to regulation and had to be replaced. While this trade has now largely petered out, these latest ideas, especially regarding AT1s, could create new similar opportunities. Having been very cautious on credit over the past 12 months, we have become more constructive in recent weeks as yields have risen and, as a result, have been selectively adding to our fixed income holdings.
Current Capital Stack Composition (% of RWAs)
Possible Future Capital Stack Composition (% of RWAs)
P2G / PRA Buffer CET1 – variable Non-binding requirement
Countercyclical Buffer CET1 – variable
Combined Buffer Requirement (CBR)
Releasable Buffer CET1 - ?
G-SIB/O-SII/SRB CET1 – variable
Capital Conservation Buffer CET1 – 2.5%
Tier 2 Pillar 1 – 2.0% 25% of Pillar 2A/R
AT1 Pillar 1 - 1.5% 18.75% of Pillar 2A/R
Minimum Requirement CET1 - ?
CET1 Pillar 2A/R
CET1 Pillar 1 (4.5%)
Pillar 1: minimum regulatory capital for credit, market & operational risk
Pillar 2 (P2A/R & P2G): firm specific requirements determined by supervisory judgement
1 The Polar Capital Income Opportunities Fund and Polar Capital Global Financial Trust are permitted to invest up to 80% and 10% respectively of their assets in fixed income securities
Jack joined the Polar Capital Financials team as an analyst in October 2017 working closely with Nick Brind on the Income Opportunities Fund.
Prior to this, he worked at DBRS Ratings, covering the Swiss market as a lead analyst, as well as UK, Dutch, Japanese and Australian banks. Before DBRS, Jack worked in the Markets Division of the Bank of England for four years, assessing financial institutions with a view to determining access to the Bank's Sterling Monetary Framework (SMF) facilities, and internal counterparty trading limits.