Minimum capital ratios
The following blog post is part of the overview of supervisory measures in reaction to the Corona crisis:Supervisory measures in reaction to the Corona crisis – Overview.
According to the ad hoc measures taken by the ECB, banks can fully use their capital buffers during this time of financial distress, including the Capital Conservation Buffer (CCB) and the Pillar 2 Guidance (P2G). This means that banks are allowed to operate temporarily – until further notice – below the level of capital defined by the P2G and the CCB.
Besides, banks can partially use capital instruments that do not qualify as CET1 capital, e.g. Additional Tier 1 or Tier 2 instruments, to meet their Pillar 2 Requirement (P2R). This measure is effectively an early implementation of the standards laid down in CRD V that originally should entry into force in January 2021). Banks will therefore benefit from relief in the composition of capital for the P2R.
Furthermore, the country-specific countercyclical buffer (CCyB) can be reduced individually by the competent national authorities. In Germany for example, the competent authority for setting the CCyB decided to reduce the ratio from 0.25 percent to 0 percent as of April 1, 2020. The reduction is aimed at strengthening the resilience of the banking system in the current situation. This measure is scheduled until December 2020 and will be reassessed.. Other national competent authorities went the same way and reduced their current CCyB rate or revoked their decision to increase the CCyB rate in the near future. Please find below an overview of the CCyB adjustments due to the COVID-19 crisis (as of April 08, 2020): (please click to enlarge)
As a summary, you can conclude that the ECB integrated three different “Corona” buffers that can be used to mitigate the effects of the COVID-19 crisis. The picture below illustrates the minimum capital requirements with and without the Corona buffers: (please click to enlarge).
The ECB highlights that the absorption of the P2G (Corona buffer 1) and the amended capital composition for the P2R (Corona buffer 3) will lead to a CET1 relief for the significant banks of € 120 bn which can be used to absorb losses or to finance the real economy. The various reductions of the country-specific CCyB rates (Corona buffer 2) are estimated to lead to an additional CET1 relief for significant banks of € 11,8 bn.
In addition to these three Corona buffers, some member states took further individual measures to support specific significant institutions. Finland, Estonia and the Netherland reduced the Systemic risk buffers leading to a CET1 relief of € 7,5 bn. Furthermore, Cyprus, Finland and the Netherlands also reduced the buffer for other systemically important institutions (O-SII buffer) and released additional CET1 by € 0,6 bn (for further details see ECB press release as of April 14, 2020).
These numbers are based on average capital requirements for credit risk. The actual amount of additional capital that can be used to extend further credit business however depends on a number of factors which banks need to analyse in order to adjust their loan origination to the Corona crisis as well as the countermeasures being discussed. For banks using the standardized approach for credit risk, possible effect of the Coronavirus focus on the amount of credit risk adjustments, value of collateral, number of new defaults and rating migration leading to increased risk weights: (please click to enlarge)
Banks using the IRB approach will have to face similar topics, however with some added complexity. For example, the additional credit risk adjustments are partly countered by the comparison with expected loss amounts, that will also increase as a consequence of the crisis. (please click to enlarge)
A rise in defaults will be reflected in the PD estimation while declining collateral values will be reflected to a lower extent in the LGD, given that banks are already required to use LGD estimates calibrated on an economic downturn: (please click to enlarge)
With respect to own funds requirements for market risk, banks are especially facing extraordinary levels of volatility recorded in financial markets since the outbreak of the crisis. In order to smooth procyclicality and to maintain banks’ ability to provide market liquidity and to continue market-making activities, the ECB announced in its press release as of April 16, 2020, that it is temporarily reducing the qualitative market risk multiplier in internal market risk models which is set by supervisors and is used to compensate for the possible underestimation by banks of their capital requirements for market risk. This temporary reduction of the qualitative multiplier aims to compensate for the observed increases of the quantitative multiplier, which can rise when market volatility has been higher than predicted by the bank’s internal model. The ECB will review its decision after six months on the basis of observed volatility.
On April 22nd, the EBA also published a series of measures targeted at the area of market risk capital requirements. Besides the market risk multiplier already covered by the ECB statement, the EBA advocates the following further changes:
- Reduce the impact of increased market volatility on the prudent valuation for banks using the more advanced core approach for the calculation of AVAs
- Postpone the reporting requirement for the new FRTB standardised approach to the third quarter of 2021
- Postpone the introduction of margin requirements of non-centrally cleared derivatives in the joint ESA’s RTS
- For banks using internal models for market risk, besides the topic of the multiplier, it is also allowed to postpone the update the sVaR historical observation period so that banks do not need to take into account the current period of increased volatility immediately
As a conclusion, banks need to analyse continuously the individual impact on RWA and capital requirements resulting from the crisis and the various measures taken, including:
- Assessing the CET1 capital relief, resulting from the several reductions as well as the reduced CET1 requirement for P2R..
- Calculating the new CCyB based on all recent changes
- Simulating / assessing the RWA effects
- Simulating / assessing of CET1 effect (EL comparison)
The simulation of the impact of COVID-19 on capital ratios is one of the biggest challenges. Boards of directors and supervisors are equally interested in a short term, medium term and long term simulation of the impact to derive possible countermeasures. We would like to support you with our PwC PASS tool (Pandemic Analysis and Scenario Simulation). PwC PASS was developed to support specifically in the important issue of simulating capital ratios and can be used with a wide range of stress parameters such as rating migrations, collateral values, risk provisioning, NPL backstop in both the standardised and IRB approaches. The tool also offers both standardised and individual reporting and analysis options. More about the PwC PASS is available in the blog post: PwC PASS – PwC’s tool for the multi-year simulation of the COVID-19 crisis on regulatory capital.