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Subtly does it by the ECB

28 July 2016 by Gary Kirk

As we wait for the results of the latest EU bank stress tests, due to be released tomorrow at 9pm CET, we were encouraged to see a couple of subtle changes to the capital treatment, which should provide considerable comfort to investors.

Firstly, and as expected, the ECB have effectively split the so called Pillar 2 capital requirements of banks into recommended (P2R) and guidance (P2G). The P2R is an integral part of a bank’s core capital and is included in the calculation for a lenders ‘maximum distribution amount’ (MDA), being the threshold at which AT1 coupons (and share dividends and bonuses) are forcibly reduced by the Regulator. However, importantly, the ECB has now confirmed that the P2G allocation will sit on top of the minimum capital requirement and the combined buffer, and as a consequence will not be used to determine the MDA. This effectively reduces the threshold of the MDA for banks by around 100bps – a considerable amount when some banks are struggling to maintain profitability and capital generation.

In addition, and over the medium term even more crucial, is the treatment of the so-called ‘counter cyclical buffer’ (CCB). This is capital that the banks are expected to reserve and then release in times of economic stress (the BoE recently cut this for UK banks – boe-support-for-uk-bank-capital), which is being phased in across the EU by the end of 2018. Under the guidance of SREP (the ECBs methodology for implementing EU law, EBA guidelines and supervisory best practice) the CCB is currently fully included in capital requirement calculations whereas this new ruling allows the CCB to be phased in. The result of which will enable banks to report a potential margin gain of 1.25% above the MDA for 2017 and 0.625% in 2018 – giving further breathing room for EU banks and more comfort to AT1 investors (as they will be further away from any coupon reduction).

These changes by the ECB should be applauded and are further evidence that the Regulators have recognised the need to make the AT1 sector a more attractive proposition; thereby supporting the long-term viability of the product. Together, these two changes mean a potential increase in bank MDA margins of 2.25% for 2017 and we were not surprised to see a significant increase in demand for AT1 product yesterday and this morning, despite the imminent release of the stress test results.

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