ECB Eyes Softening Stress-Test Impact on Capital Requirements

  • Lautenschlaeger says capital expectations could be separated
  • AT1 coupon payments can be restricted on buffer breach

The European Central Bank is considering changing how it uses stress tests to set bank-specific capital requirements in a move that may alleviate debt investors’ concerns about payments on lenders’ riskiest bonds being reduced or stopped without warning.

Sabine Lautenschlaeger, vice chair of the ECB’s Supervisory Board, raised the possibility of splitting supervisory capital expectations into binding requirements and informal guidance. A bank that meets its requirements, but not the guidance, wouldn’t automatically face restrictions under European Union law on earnings distributions, including coupon payments on additional Tier 1 debt, she said in a speech in Frankfurt on Wednesday.

For supervisors to use capital guidance “when processing insights from hypothetical scenarios,” such as those in stress tests, would mean a shift in policy, Lautenschlaeger said, since at present the ECB factors the results of such assessments into binding requirements.

“There is a bit of a trend of regulatory backpedaling,” said Paul Smillie, a Singapore-based analyst at ColumbiaThreadneedle, which manages about $466 billion globally. “I think we are working toward a situation where the likelihood of an AT1 coupon payment being skipped is lower than it is currently perceived to be.”

‘Total Capital Level’

The change to SREP floated by Lautenschlaeger “would not change the total capital level,” she said. “It would just be divided differently between requirements and guidance. If a bank observed the binding capital requirements, but not the guidance, this should not automatically lead to a formal supervisory measure.”

This would also bring ECB practice into line with the European Commission’s thinking. In a note earlier this year, the EU’s executive arm said capital requirements “cannot be imposed in order to address hypothetical situations” such as those set in the adverse scenarios of stress tests. Non-binding capital guidance could be changed based on a bank’s performance in such an assessment, however.

The ECB’s work on this issue is ongoing, Lautenschlaeger said.

Under EU rules, once a bank’s losses pierce the capital level comprising statutory and lender-specific requirements and its combined buffers, it must prevent money from leaving the business: dividends, bonuses and AT1 are capped by the so-called maximum distributable amount.

‘Particular Protection’

When banks miss a coupon on AT1 securities, such as contingent convertibles, or CoCos, it’s gone forever, unlike a dividend or a bonus, which can both be made good when a lender’s fortunes improve. Regulators came up with the securities in the wake of the financial crisis to preserve capital in a stressed lender and avoid government bailouts. They are undated and interest payments on them are optional.

In its note, the commission said AT1 investors may “deserve particular protection relative to the other stakeholders concerned.”

“The SREP is a minimum requirement and that will remain,” said Simon Adamson, an analyst at CreditSights Inc. in London. “The problem is that you now have instruments like CoCos that have triggers based on capital ratios and regulatory requirements, and you don’t necessarily want automatic suspension of payments if ratios are breached. Pillar 2 can be set in a way that doesn’t translate into an automatic trigger of those instruments.”

The question is when this change is going to come, Adamson said. “I suspect it will be in the review of 2017 SREP requirements, towards the end of this year. If senior people at the ECB are talking about it in a speech, it’s pretty sure they’re going to do something.”

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