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.