European Commission Communication: Recalibration rather than revolution

The European Commission (EC) published a Communication last week on the competitiveness of the European Union (EU) banking sector and the single market in banking, setting out an agenda to reduce national fragmentation and simplify prudential, resolution and reporting requirements. Building on the recommendations of the Draghi and Letta reports and recent work by the European Banking Authority (EBA), European Central Bank (ECB) and other European authorities, the Commission is now seeking feedback before presenting a package of legislative and non-legislative measures in the first quarter of 2027.

Overall, we view the measures proposed in response to these challenges as representing targeted recalibration rather than a complete revolution. The aim is to improve resource allocation, proportionality and banks’ ability to operate at scale while ensuring banks continue to maintain strong capital and liquidity positions. This forms part of the broader effort to strengthen the single rulebook and complete the “Banking Union”, building on the simplification initiatives announced earlier in the year.

Importantly for Additional Tier 1 (AT1) investors, the Communication contains no proposal to change the structure or loss-absorbing features of AT1 instruments. This was broadly in line with expectations following the EBA’s report in June. As discussed in our previous blog, we continue to view the removal of AT1 from the European bank capital stack as unlikely.

Reducing fragmentation in the EU banking sector

The first challenge is the fragmentation of the EU banking market, which limits scale, resource allocation and cross-border diversification.

The package would make it easier for the banking groups to manage capital and liquidity at the consolidated level, while ensuring that subsidiaries remain adequately supported in both going concern and crisis situations. It also intends to use its enforcement powers where unjustified national intervention in cross-border mergers and acquisitions breaches EU law.

In practice, this could reduce capital and liquidity trapped at individual entities, improve group-wide returns and potentially improve funding access for larger, more diversified groups. The ECB estimates suggest that removing constraints on subsidiary liquidity could release around “€230bn of high-quality liquid assets” easing some of the structural constraints to cross-border consolidation. Greater cross-border mergers and acquisitions (M&A) could create larger, more resilient institutions. Consolidation has historically progressed slowly, but we have seen a pick-up in merger announcements in recent years given the supportive backdrop for banks. However, this is unlikely to eliminate political hurdles; Germany’s resistance to a potential takeover of Commerzbank acts as a helpful reminder that domestic pressures can still shape cross-border banking deals.

A proposed change would replace the original 2015 European Deposit Insurance Scheme proposal with a simpler framework to address potential liquidity shortfalls in national deposit guarantee schemes. A less fully mutualised structure could prove more politically acceptable than the original proposal. Depending on its final design, it could strengthen depositor protection and support more orderly management of bank failures.

Applying international rules to European banks

The second challenge is the insufficient consideration of EU-specific features when international standards are transposed into the EU regulatory framework.

Although Basel III has applied since January 2025, the Commission plans to monitor implementation across jurisdictions and consider adjustments to market-risk rules, unrated corporates, mortgage lending and strategic financing, while aiming to preserve resilience supporting EU bank competitiveness.

For banks, the effect will depend on the degree of recalibration, as more proportionate risk weights could improve their capital efficiency. The Communication does not propose an across-the-board reduction in capital standards, although some measures could lower requirements for particular banks or exposures.

Simplifying capital and resolution requirements

The third challenge is the growing complexity and cost of the EU regulatory framework following successive revisions.

The Commission plans to simplify microprudential rules, enhance the targeted application of Pillar 2 Guidance and propose removing Pillar 2 requirements linked to the leverage ratio. Removing this requirement would provide modest balance-sheet flexibility to small number of banks currently constrained by the leverage ratio, but the sector-wide impact would be limited. Another area of focus is to simplify the Minimum Requirement for Own Funds and Eligible Liabilities framework (MREL) and align it more closely with international Total Loss Absorbing Capital (TLAC) standards.

Greater predictability around redemptions and buybacks would improve banks’ ability to manage their capital and funding stacks. It could also facilitate refinancing exercises for MREL-eligible debt, although banks would still be required to maintain sufficient loss-absorbing capacity and demonstrate that their resolution strategies remain credible.

These changes should reduce operational complexity and regulatory uncertainty, but they are unlikely to produce material capital relief for most banks.

The Commission also intends to simplify the macroprudential toolkit, including the countercyclical and systemic risk buffers, and harmonise the framework for other systemically important institutions. If these buffers are made more releasable in stress, banks could absorb losses by drawing down these buffers without immediately breaching their combined buffer requirement. This could reduce the risk of AT1 coupon restrictions arising from a breach of the combined buffer requirement.

Overall, we view the Communication as modestly positive for European bank credit, but it is unlikely to impact near-term spreads significantly. The proposals are a recalibration rather than a revolution and do not alter our view of the strength of the European regulatory framework or the role of AT1 instruments in banks' capital structures. For investors, the key question will be whether the final legislative proposals produce meaningful changes to banks' capital flexibility or risk appetite. At this stage, we believe this is a case of regulatory tweaking rather than a catalyst for moves in credit spreads or banks' capital strategies.