Audience: CFOs; CROs; Heads of Capital Planning; Heads of Stress Testing

Reading time: 5-7 minutes

At a glance: Through the pandemic, banks did not utilise their buffers as much as regulators might have expected. Sam Woods, CEO of the PRA, proposes a radical new way of looking at bank capital, and particularly the buffer framework, that would allow much greater scope for regulators to release capital during periods of stress, with the aim of enabling banks to keep lending through a crisis.

Sam Woods, the chief executive of the PRA, delivered a speech. 

There’s nothing particularly startling about that: Mr Woods frequently makes speeches. However, this time he made a speech about concept cars.  He talked about how futuristic they can be, the halo effect they can create, and how they can be used to open people’s minds to new ideas.

Of course, the speech was not really about concept cars.  It was about bank regulation, particularly capital buffers, and how bank capital is – or should be – constructed.

The current structure of bank capital requirements is highly complex.  There are multiple constituent parts, a range of eligible capital instruments, and a complex and interlinked set of buffer requirements.

Through the course of the pandemic, regulators released one of the current types of buffer – the countercyclical buffer (CCyB) – and made numerous public pronouncements encouraging banks to utilise their other buffers if necessary, in order to continue to support the economy.

However, few, if any, banks did utilise their buffers. The FSB noted “…there are indications that banks might be reluctant to dip into their buffers if needed to meet credit demand, in spite of the flexibility in the regulatory framework. Authorities released countercyclical capital buffers quickly, but such buffers were not always available or of sufficient scale to provide substantial additional macroprudential space.” [1] A significant contributor to banks not using their buffers was government support schemes and work by the international regulatory community to mitigate the pro-cyclical effects of IFRS 9 – although that mitigation will roll off over the coming years. But as the FSB notes another significant contributor was a perception by banks that utilising buffers would be seen by the market as a sign of weakness as well as the risk of constraining banks’ ability to pay dividends or bonuses if they went below their MDA threshold [2].

The regulatory principle of buffers is clear and simple: banks should build up buffers of capital during good (or at least normal) times, which they can then use in harder times to absorb losses while continuing lending to support the economy.  This approach obviously depends on banks and markets accepting that using buffers is a good thing overall and not a sign of weakness.  

At the core of Mr Woods’ proposal is a radical simplification of how capital is defined.  When you strip away the concept car analogy, it is clear that a lot of work has gone into the approach the speech outlines and the proposal is meant to generate debate in the global regulatory community. It could also be seen as an example of asking for the unattainable, in order to achieve a significant improvement on the status quo. Whether as a conversation starter or the opening salvo in a negotiation, the broad concept Mr Woods outlines has much to recommend it.

As stated earlier and shown in Figure 1 below, the current structure of bank capital is highly complex.  Mr. Woods proposes to change that in a few fundamental ways:

  • Do away with all of the existing capital buffers, replacing them with a single buffer over which regulators have significant, and very flexible, control;
  • Do away with the existing pillar one capital requirements, replacing them with a simpler, potentially lower, minimum capital requirement; and
  • Have all capital requirements met with more loss-absorbing common equity (what is currently called common equity tier one).

Figure 1: The current capital stack versus the proposed capital stack

There is, as one would expect, rather more to the proposal than just a simplification of the capital structure. The revised proposal would:

  • Balance macro- and micro-regulatory objectives, by ensuring not only that each bank holds an appropriate amount of capital, but that the aggregate amount of capital in the system is also sufficient;
  • Retain some level of risk sensitivity – the speech recognises that riskier banks should hold more capital than their less risky peers;
  • Allow a progressive approach to releasing the buffer, as opposed to the “all or nothing” approach that the current framework requires;
  • Have stress testing as a key component of the regulatory capital-setting process – with an expectation that the range of stress tests would be broader and more frequent under this framework;
  • Retain a leverage-based backstop to capital requirements.

While the proposal has several benefits in terms of simplicity and flexibility, there are some challenges:

  • The approach would require a degree of sophistication in stress-testing approaches that firms may struggle to achieve in the short-term;
  • The openness and flexibility of the approach will likely be less attractive in the EU, given its more rules-based regulatory framework;
  • The issue of how to maintain transparency of banks’ capital requirements would need to be addressed – the size of the buffer and its composition would need to be subject to some level of public disclosure in order to maintain a level of market discipline;
  • Related to the transparency point, each of the current buffers is in place for a particular purpose, and combining them all into one large “super buffer” might risk reducing some supervisory clarity of bank capital requirements;
  • The speech does not address the effect on resolution and loss-absorbency in resolution (e.g. MREL);
  • Related to the MREL point, it’s not clear what banks would do with their existing AT1 and T2 capital instruments, given that the proposal would require all capital to be held in the form of CET1;
  • How the proposal would affect home:host regulatory discussions is not clear: at one level, if the PRA’s priority is to ensure UK banks keep lending in the UK, then as long as UK entities have their new “super buffer” in place in the UK, non-UK regulators’ actions in respect of non-UK entities should be less of an issue;
  • Rating agencies have their own internal models, which inform their view of the appropriate capital amount banks should hold in order to maintain particular rating grades.  Changes in the regulatory buffer requirement, particularly where buffers were released as a result of a downturn, would not affect rating agency methodologies and views which could give rise to a situation where a bank felt it did not wish to reduce its capital below the level that might trigger a rating downgrade.
  • Mr Woods acknowledged this reluctance by talking about a “market-imposed capital requirement” but suggested that regulators could influence this by providing the market with assurances that banks would not face consequences from using their buffers. Influencing market sentiment is possible, but it is a tall order.

Notwithstanding the challenges, Mr Woods’ proposal would simplify several of the conversations about capital, not least in terms of capital instruments. It would also significantly increase regulators’ ability to vary banks’ regulatory capital requirement in a time of stress, allowing banks to continue supporting the economy.

Mr Woods’ speech is an attempt to accelerate and influence an ongoing international conversation among regulators about how to ensure that the buffer regime works as intended, and to address banks’ and the market’s perception that utilising buffers is a sign of weakness. It is an important topic for regulators to review and get right.

The global workstream looking at this, led by the Basel Committee on Banking Supervision, is likely to take a careful and measured approach to proposing revisions to the bank capital framework, especially given how much effort has been put into it since the Global Financial Crisis and how long its final components are still taking to be implemented. Mr Woods, for his part, made clear that the UK will not go it alone here – it will remain aligned to international standards.

With concept cars, the eventual product sold to the consumer often bears only passing resemblance to the radical prototype. This is likely to be the case with any reform of the buffer framework, but we should keep an eye out for Mr Woods’ concept having an influence – some simplification of the buffer regime, and an expansion of the extent to which regulators can release buffers, both generally and in relation to specific sectors or banks, would seem to be the most likely components. A regime that achieves those aims would likely be better placed to respond to the next crisis – whatever its origins.

[1] Lessons Learnt from the COVID-19 Pandemic from a Financial Stability Perspective: Final report. Financial Stability Board, 28 October 2021

[2] MDA, or maximum distributable amount, becomes relevant when a bank fails to meet its combined buffer requirement – the sum of capital required by pillar one, pillar two, capital conservation buffer, CCyB, G-SIB or D-SIB buffer and any other buffers that its regulator requires.  Once a bank’s capital amount falls below the combined buffer amount, it must calculate its MDA in accordance with CRD Article 141 and it may not pay dividends, buy back shares or pay bonuses that exceed its MDA.