EU banks eye savings following Pillar 2 update

ECB estimates CET1 relief of 90 basis points

Pillar 2 add-ons will no longer have to be met using the highest quality capital by European Union banks once new regulations come into force, which could reduce lenders’ Common Equity Tier 1 (CET1) requirements by 90 basis points on average.

The fifth Capital Requirements Directive (CRD V) will align capital requirements under Pillar 2 with those under Pillar 1. Of banks’ total Pillar 2 requirements, 56% will need to be covered by CET1 capital, around 18% by additional Tier 1 (AT1) and about 25% by Tier 2 instruments. 

The European Central Bank’s (ECB) policy when assigning Pillar 2 add-ons has been for the requirement to be met entirely using CET1 capital. After the switch to CRD V, therefore, banks will “save” roughly 44% of the CET1 previously held to satisfy their Pillar 2 requirements.

The overall CET1 demand of banks covered by the 2018 Supervisory Review and Evaluation Process (SREP) was 10.6% of risk-weighted assets (RWAs). Of this, 2.1% related to Pillar 2 requirements. Once CRD V takes effect, just 56% of this will have to be met with CET1.

Of large EU banks subject to SREP 2018, Nordea has the highest Pillar 2 requirement of 3.2%.

Deutsche Bank had the second-highest of 2.75%. But on December 10, it announced this would be reduced to 2% as of January 1, 2020. 

Who said what

“The Capital Requirements Directive V contains new rules on the quality of capital for Pillar 2 requirements, which will impose a change in the policy the ECB has pursued until now – that of focusing only on Common Equity Tier 1, or CET1 for short. When this change was being negotiated, ECB Banking Supervision and the European Parliament voiced their concern about this change, warning that high quality capital was essential. According to our calculations, the change will generate an average reduction in CET1 requirements of 90 basis points, as banks will be able to rely on lower quality additional Tier 1 and Tier 2 capital, which is now available at favourable conditions,” – Andrea Enria, chair of the supervisory board of the ECB, December 12.

What is it?

EU banks directly supervised by the ECB are set their Pillar 2 requirements following the results of its annual Supervisory Review and Evaluation Process.

Each bank is also assigned a Pillar 2 guidance (P2G) add-on, a non-binding requirement that should be held to ensure they have enough of a capital cushion to withstand a future financial crisis.

The SREP is a bank-by-bank evaluation of capital adequacy undertaken by the ECB, which takes into consideration each firm's business model, governance and risk, capital and liquidity buffers to define appropriate minimum capital requirements for the following year.

Why it matters

CRD V’s Pillar 2 capital giveaway comes as a relief to banks fretting about the effects of Basel III. Large banks could see minimum Tier 1 capital requirements jump 25% on average once the reforms are fully implemented, a big chunk of which will have to be covered with CET1. 

The Pillar 2 relief could offset some of this Basel III uplift. European policymakers are also looking into a larger shake up of the Pillar 2 methodology. José Manuel Campa, chairman of the European Banking Authority, speaking at a conference on Basel III on November 12, said these should be calibrated to take into account the Basel reforms. 

Perhaps with a reformed Pillar 2, the capital blow of Basel III will be made that little bit softer for EU banks.

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