Jérôme Legras is a managing partner and head of research at Axiom Alternative Investments
Last week, the ECB issued a set of 17 recommendations to “simplify” bank capital, regulation and supervision. Perhaps unsurprisingly, most investors and analysts are left even more confused.
The motivation is clear. The US and the UK are now clearly embarked on a path of financial deregulation to support growth, and Europe is following suit. But the end result will probably be a slow-moving tangle of awkward political compromises.
Here’s a summary of the most significant proposals and their probable market impact. Alphaville has mainly focused on the market impact of these recommendations, and above all the possible reform of the AT1 market — one of our favourite subjects.
The Schrodinger Buffers
Two recommendations
The European Banking Authority has 13 different capital buffers, and exiting EBA chair José Manuel Campa is probably the only one that can name them all. Simplification does seem in order.
The ECB proposes to encourage reciprocal treatment of country-specific buffers and to merge some of the existing buffers into 1) a releasable buffer and 2) a non-releasable buffer, the difference being that “releasable buffers” are supposed to be used in macro downturns.
This will probably only have a limited impact on the market and capital planning. The simplification is marginally useful, but changing the name tags of the buffers will not change the capital that banks’ managements choose to hold. The Covid-19 crisis was the perfect proof that banks do not want to use “releasable” buffers, simply because they (obviously) do not want their capital ratios to look weaker in periods of increased risk and uncertainty.
Ze small banks
One recommendation
There’s only one recommendation applicable to German banks, err, sorry, to small banks, but it might be the most significant one and presumably key to gain approval from German policymakers.
The ECB suggests that the “small bank regime” which currently exists for banks with a balance sheet smaller than €5bn should be extended to larger banks and improved, possibly inspired by the UK or Swiss regimes — or the US one (with only one prudential approach retained, either risk weight-based or leverage-based). Those banks don’t usually issue securities so the market will not really care.
Improve regulation and supervision
Four and five recommendations respectively
The ECB report includes the usual “asks” from European bodies: more regulations and fewer directives, swift implementation of the banking, capital market, and savings unions, improvement of the single rule book, etc. There is nothing new here and don’t hold your breath on the grand Unions proposals.
A large share of the report is dedicated to better supervision, a noble initiative, but with limited short-term impact for investors (and obvious long-term benefits.) The most intriguing recommendations are:
— A simplification of the stress tests, which are currently very cumbersome and expensive and usually only interest the market for approximately 15 minutes.
— A slightly odd suggestion that the ECB should set a goal for the total bank capital outstanding — something that is probably best left to the market.
Improve reporting
Three recommendations
Make reporting automatic, machine-readable, more frequent and harmonised? Where do we sign up?
Overhauling capital instruments
Two recommendations
The coexistence of “total loss absorbing capacity” and “minimum requirement for own funds and eligible liabilities” in the EU has always been an anomaly. Both serve the same purpose and have very similar characteristics. Logically, the ECB suggests they should be merged.
And finally, we get to the crucial bit of the report, at least for investors: the AT1 market. For those blissfully unaware, “Additional Tier 1” securities are bonds designed to be wiped out or turned into loss-absorbing capital in a crisis, and a big pillar of the post-2008 European banking system. Naturally, big red newswire headlines like “ECB’S GUINDOS SAYS PROPOSING TO MAKE AT1 MORE LIKE EQUITY” have therefore attracted attention. But what does it mean exactly?
The issue the ECB is trying to solve isn’t whether AT1 are gone-concern capital: the cases of Credit Suisse or Banco Popular have made abundantly clear that when a bank is failing, AT1s provide some necessary capital relief. The ECB wants to see AT1s providing capital relief while a bank is still in operation.
Many pundits have suggested that the Credit Suisse debacle was the reason for the proposed AT1 reform, but it was almost certainly Covid: supervisors were disappointed that banks didn’t dip into their buffers or skip AT1 coupons during that period of extreme stress. The ECB has therefore proposed two options:
— Replace AT1 capital by CET1 capital. However, the text strongly suggests that the ECB is not a big fan of this option, which would send the banking sector four decades in the past, sharply increase its cost of capital and reduce lending capacity.
— Make AT1s riskier. But how? The report unfortunately doesn’t offer any suggestion.
Should the second option be adopted (and it is by far the most likely), what would this mean for current AT1 bonds? The ECB’s vice-president Luis de Guindos made it very clear at last week’s press conference that this would only apply to new AT1 bonds. Yes, you read that correctly, we will possibly get a new massive Legacy Tier 1 market. The good old days might be back.
So what will happen with the old AT1 bonds?
Good question. There is a risk that banks simply keep old AT1 bonds forever as they would still be eligible as capital but cheaper, because of their lower risk. The final outcome will depend on the transition rules the EU chooses to adopt.
Loosely speaking, there have been three types of approaches to transition periods in Europe:
— The convoluted, almost impossible to understand transition rules from Basel II to Basel III (which admittedly lead to incredible investment opportunities by carefully selecting individual securities).
— The simple Solvency II / CRR2 approach: set a fixed deadline of 5-10 years hence and every legacy instrument phases out of capital on that day.
— The pragmatic approach: banks are allowed to keep existing bonds as capital, but only up to the day when they have their first option to redeem.
The consequences of various options are similar (but differ on the details): extension risk is going down, and banks will be strongly incentivised by supervisors and regulations to redeem existing AT1 bonds.
What about new AT1? What will they look like? The report says absolutely nothing about this, so we can only offer a few guesses.
— Coupon rules could be stricter — maybe inspired by the new Swiss rules where banks are not allowed to pay coupons if their one-year average of quarterly P&L is negative.
— AT1 triggers could be set much higher — everyone know that the current trigger levels are far too low to have any meaningful chance of being triggered in a going-concern scenario.
— The general AT1 format could go back to the old German format applicable in the 2000s, where coupons and redemptions were linked to the annual P&L and reserves of the bank. Investors in some highly complex Commerzbank, HSH or NDB securities know that this creates a genuine transfer of risk to investors (but makes the bonds still acceptable by the bond market.)
The AT1 market reaction to all this yesterday was “meh”. That’s a reasonable reaction: the ECB recommendations are just that, “recommendations” that are offered to the European Commission. In turn, the Commission will make its own report in 2026. This would then translate into legislative proposals that could follow the usual “trilogue” process with the European parliament and the EU Council. These might be adopted in 2027 and implemented in 2028 — but it will probably be later.
The important “Crisis Management and Deposit Insurance” framework package started in 2022 is only now reaching its final legislative stages, so whatever comes out from the ECB proposals, it’s almost certainly not coming any time soon.
