• Banks' Pillar 2 capital requirements should be disclosed
  • Law should be reviewed to consider flexibility on AT1 payouts

Europe’s banking law should be amended to prevent banks depleting capital to pay shareholders, employees and junior creditors, the European Banking Authority told lawmakers.

Restrictions on dividends, bonuses and hybrid bond coupons kick in as soon as banks start to eat into the common equity Tier 1 capital -- common stock and retained earnings -- needed for the various cushions regulators can impose. When that happens, lenders are obliged to calculate the Maximum Distributable Amount, or MDA, which caps how much they can pay out.

Ambiguous language in the European Union law implementing the framework set out by global regulators on the Basel Committee on Banking Supervision has created uncertainty about exactly which layers of capital have to be taken account of when potential payouts are calculated. That’s because bank capital is divided into two blocks and European law isn’t clear whether lenders must consider one or both in the calculation.

“Timely and full capital restoration is precisely what is pursued by the calculation of the MDA,” the EBA said in an opinion published late on Friday. Therefore the calculation of what is available to pay out should be made taking into account both blocks of capital, the authority said.

The law’s logic dictates that banks should ensure they could meet all of their capital requirements when calculating MDA, the EBA said. It asked the European Commission to change the legislation to make that clear.

Under the Basel framework, so-called Pillar 1 buffers include the capital conservation buffer, systemic risk buffers and the countercyclical buffer. Pillar 2 requirements instead are set to capture risks specific to each lender’s business and as things stand, the amount may or may not be made public.

Capital markets transparency rules mean banks should publish the Pillar 2 requirement, because the effect on their ability to pay dividends and hybrid bond coupons may mean it meets the criteria for inside information, the EBA said. Daniele Nouy, head of the European Central Bank’s supervisory arm, has told banks not to publish the amount set.

Supervisors in the EU should “require institutions to disclose MDA-relevant capital requirements” or “should at least not prevent or dissuade any institution from disclosing this information,” the EBA said.

Along with tougher capital requirements, another key plank in post-crisis bank regulation is supervisors’ ability to act long before critical capital thresholds are breached to force lenders to rein in their risk-taking. While payout limits are one of the most powerful tools in this area, the EBA raised the possibility of allowing some limited flexibility in payments on additional Tier 1 bonds.

Known as CoCos, for contingent convertible bonds, AT1 notes are a new class of instrument regulators designed to allow banks to bring debt investors into their capital structures. They are undated and coupon payments are fully optional. Since debuting in April 2013, CoCos have burgeoned into one of the fastest-growing public debt markets, one which analysts say will eventually grow to about double its current size.

The EBA said it favored “some review” of rules prohibiting payments that apply in all cases when no profits are made.

Possible changes “should apply only in exceptional circumstances when additional flexibility in distributions is necessary in order to support the implementation of a capital conservation plan,” the EBA said. “Such a review should also not be seen to undermine the clear policy objective, supported by the EBA, that distributions on AT1 instruments should be fully discretionary.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE