![Risk.net](https://www.risk.net/sites/default/files/styles/print_logo/public/2018-09/print-logo.png?itok=1TpHrpuP)
Grand designs? Time to rein in the Pillar 2 project
Pillar 2 capital add-ons are becoming increasingly elaborate
In the TV show Grand Designs, presenter Kevin McCloud follows the trials and tribulations of individuals attempting elaborate and unorthodox homebuilding projects. These go far beyond the traditional conservatory extensions. Often, the projects spiral in cost and scale and take longer to complete than planned.
European financial watchdogs may see a little of themselves in these intrepid homebuilders in the context of Pillar 2 capital add-ons: bank-specific buffers that apply on top of minimum requirements.
Once, they were thought of as straightforward additions to the Pillar 1 risk-based capital framework; like a summer room to a south-facing home. Today, they more closely resemble the fiendish constructions showcased in Grand Designs: complex, confusing and in danger of overwhelming their host properties.
Initially, Pillar 2 buffers consisted of a single add-on to cover risks not captured by Pillar 1 charges. But in 2016, European policy-makers split them in two to create separate Pillar 2 requirement (P2R) and guidance (P2G) amounts.
Following passage of the fifth Capital Requirements Directive, Pillar 2 add-ons are poised to become even more complicated. In future, banks will be allowed to meet their total Pillar 2 amounts using Additional Tier 1 and Tier 2 capital, instead of just Common Equity Tier 1.
The add-ons have also fluctuated in size over time. In 2015, the aggregate Pillar 2 add-on for European banks was 3.1% of risk-weighted assets (RWAs). In 2016, the combined P2R and P2G was 4.1%. This year, it’s dropped down to 3.6%. But some banks’ P2R amounts are much higher. At three banks, P2R charges are equivalent to 78% of their Pillar 1 minimum requirements.
The evolution of Pillar 2 amounts from basic to byzantine is emblematic of supervisors’ concerns about the Pillar 1 framework. Uniform minimum requirements do not, and perhaps cannot, ensure an appropriate level of capitalisation for Europe’s exotic assortment of banks. In addition, many firms routinely fall short of risk management standards set by the European Central Bank and national authorities, bolstering the case for large add-ons.
Evidence of risk management shortcomings could explain why watchdogs have turned to Pillar 2 as a cure-all. But in future, these add-ons may not be the safeguard they are today. By making AT1 and Tier 2 capital eligible for meeting Pillar 2, supervisors will reduce the mandated amount of equity capital banks must hold to satisfy regulatory requirements. An EBA official has also called for Pillar 2 requirements to be lowered across the board in anticipation of Basel III, which is expected to lift Pillar 1 minimums.
They started out as small and simple, became large and complicated, and in future may settle down as something in between. What’s true of the typical Grand Designs project may hold for Pillar 2 add-ons.
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (point 2.4), printing is limited to a single copy.
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (clause 2.4), an Authorised User may only make one copy of the materials for their own personal use. You must also comply with the restrictions in clause 2.5.
If you would like to purchase additional rights please email info@risk.net
More on Our take
FX forwards dealers face added challenges in P&L analysis
Mark-out tools for forwards and swaps trading may not be a panacea
Can history resolve factor investors’ p-hacking questions?
Quants seek reassurance in the far distant past
Insurance double-hatters like Apollo can expect more scrutiny
Regulators are homing in on conflicts of interests at private-equity-owned insurers
Podcast: Lorenzo Ravagli on why the skew is for the many
JP Morgan quant proposes a unified framework for trading the volatility skew premium
Quants see promise in DeBerta’s untangled reading
Improved language models are able to grasp context better
Counterparty risk model links defaults to portfolio values
Fed’s Michael Pykhtin proposes using copula models to capture effects of margin calls on default risk
Does Basel’s internal loss multiplier add up?
As US agencies mull capital reforms, one regulator questions past losses as an indicator of future op risk
Is JSCC-CFTC stalemate about to be broken?
Japan CCP gains allies in battle to clear yen swaps for US clients, but CFTC shakeup could dash hopes