SREP 2018: A new look capital stack? SREP 2018: A new look capital stack?

The EBA is pushing the ECB to modify its current approach to the double counting of Common Equity Tier 1 capital. A change to the stacking order seems certain to follow, and could drive up effective CET1 demand by as much as 150 bps. Banks should urgently review their current funding mix, and consider whether they may need to issue fresh convertible or hybrid capital.

The EBA's proposed SREP guidelines contain a potentially explosive detail. Buried in the small print, paragraph 400 of the new draft states that banks' own funds held under Pillar II Guidance (P2G) can no longer be used to meet any other regulatory requirement. In particular, funds covering P2G cannot be used to make up any shortfall in Additional Tier 1 (AT1) or Tier 2 (T2) capital.

The SSM's latest SREP methodology booklet confirms the new approach. It specifically states that, in light of the EBA's new guidelines, the ECB expects to change its current stance of allowing double counting.

Unless the requirement for P2G to be composed of Common Equity Tier 1 (CET1) capital were to be changed - which seems highly unlikely - the elimination of double counting seems certain to lead to the first major change to the stacking order of regulatory capital since 2016, when the capital conservation buffer was phased in.

If that seems a minor technicality, don't be fooled. This is a potentially far-reaching alteration. Banks could face a significant uplift in their effective CET1 requirements. In theory, this could equate to as much as 1.5% of risk-weighted assets. What's more, it seems likely that some banks have yet to detect the forthcoming change in approach.

Let's look at the proposed change in more detail.

• At present, a bank's effective CET1 requirement is equivalent to its OCR¹, plus the bank's P2G or any shortfall in issued AT1/T2 - whichever is the greater.
• In future, it seems likely that the CET1 requirement will constitute the OCR plus the P2G and any shortfall in AT1/T2. Figure 1 provides a purely indicative illustration of this change.

To consider a hypothetical example, imagine a bank with an OCR of 9%; Pillar II Guidance of 100bps; and no issued AT1 - in other words, an AT1 shortfall of 150bps.

• Under current SREP practice, the bank's CET1 requirement is effectively 10.5% (i.e. the OCR of 9% plus the AT1 shortfall of 1.5%)
• All else being equal, in future we would expect the imagined bank to face an effective CET1 requirement of 11.5% (i.e. the OCR of 9%, plus the AT1 shortfall of 1.5%, plus the P2G of 1%).

The latest EBA data suggests that around 60% of reporting banks had some form of AT1 shortfall in at the end of the first half of 2017. About 40% of the SSM's less well capitalised banks had an AT1 shortfall at the same date. Furthermore, some institutions in the latter group have limited experience of issuing convertibles or hybrid capital.

In summary, what may at first seem to be a technical alteration to the SREP could have a significant capital impact for some banks in the SSM. Nor is it entirely clear when the new approach will be enforced. The new EBA guidelines apply from January 2019, but it's not impossible that the change could be introduced during the 2018 SREP.

To be on the safe side, banks should act immediately to review their funding mix and, if required, to build up sufficient levels of AT1/T2 capital as soon as possible.