European bank capital requirements – steady as it goes

As part of its supervision mandate, the ECB carries out an annual SREP (Supervisory Review and Evaluation Process) in which it examines banks’ risks and produces capital requirements and guidance for each individual bank. These additional capital requirements (referred to as ‘Pillar 2’) supplement the legally binding required minimum for each bank (referred to as ‘Pillar 1’). Pillar 1 risks are captured via appropriate weighting of assets, i.e. RWAs or risk-weighted assets, through which the regulation assigns different weights to various assets, depending on their riskiness. Pillar 2 is intended to capture those risks that cannot be accounted for through the rulebook, e.g. internal governance, liquidity risk, operational risk, etc. Pillar 2 is further divided into (i) a requirement, or P2R, that can be filled with a combination of common equity, AT1s and T2s, and (ii) guidance, or P2G, which can only be filled with common equity. As the name suggests, P2R is binding, whilst banks will still want to meet and exceed P2G – even if a breach of the latter does not carry as significant consequences.

All else being equal, higher Pillar 2 add-on for a single bank indicates build-up/existence of risks that cannot be fully captured through the rulebook (Pillar 1) and may pertain to specificities of the bank’s business model. This is to be expected as rules cannot be drafted to account for each and every risk associated with the large and complex balance sheets of banks.

This year we have seen failures of Credit Suisse, Silicon Valley Bank, as well as numerous other smaller regional banks in the US. Meanwhile regulators have had the benefit of learning whether there are any other risks to the system that might have not been accounted for in the existing regulations (either Pillar 1 or prior year Pillar 2 add-ons). Indeed, a build of up any such risks would likely be revealed through the 2023 SREP scoring process and as a result higher Pillar 2 add-ons applicable to banks from 1 January 2024.

The results of the 2023 SREP process were published this week and have been very encouraging, however. First, the overall scores for banks (based on a cohort of 106 institutions) remained at 2.6; the score is assigned on a scale of 1 to 4 where 1 indicates that there is a low risk a bank may face material losses, and 4 indicates there is a high risk that a bank may face high losses. 71% of institutions had unchanged scores, 15% have seen improvements and 14% scored worse than the year before.

In terms of how these scores translated into the overall capital requirement for banks (this includes Pillar 1 + Pillar 2), once again European banks have seen only a very slight increase to 15.5% from 15.1% in the prior year – this change was primarily driven by an increase in average countercyclical buffer to 0.6% from 0.2% the prior year. Within the total capital requirement, the P2R component changed only very slightly to 2.25% from 2.15% while P2G was unchanged at around 1.3%. In total, Pillar 2 add-on represented ca. 22% of the overall capital requirement, which is very much in line with the prior years.

All in all, we believe the results are encouraging and point to the fact that the sector headwinds of 2023 have not revealed material shortcomings in the capital requirements of the European banking sector, positioning the space well for this coming year, especially in the context of record profitability and improved net interest margins throughout the industry.