Pillar 2 Guidance (P2G): Banking regulations: what has changed?

The Covid-19 crisis has disrupted European banking supervision rules. The temporary reduction of certain capital requirements, approved in March 2020, will be extended to next year as planned. The P2G buffer (Pillar 2 Guidance) will not need to be reconstituted before the end of 2022. The method of calculating P2G will also evolve, as announced this summer by Andrea Enria, President of the Single Supervisory Mechanism (SSM).

A few reminders about bank capital requirements

Banking institutions’ capital is broken down into several layers that complement each other:

      • The Pillar 1 and Pillar 2 Requirements (“P2R”) are legally binding on banks, as is the Combined Buffer Requirement (“CBR”).
      • The Pillar 2 Guidance (P2G) has the distinctive feature of being legally non-binding. However, it enters into the calculation of total capital requested from banks and makes it possible to define the distribution capacity to shareholders (dividends, share buybacks). As a result, each institution takes this recommendation into account. P2G is designed to protect financial institutions in the event of an economic or financial crisis.
      • Banks report on a capital ratio that includes all of these layers of capital, excluding P2G, to which an additional margin of safety is generally added in order to remain above the required level applied to them. This management buffer implicitly includes P2G requirements.

In times of stress, the ECB authorises banks not to apply the P2G buffer. The CBR can also be temporarily lifted in exchange for certain limitations on the payment of dividends, bonuses or coupons on AT1* securities. The situation then corresponds to the following graph:

New announcements regarding the “P2G”

Following the outbreak of the Covid-19 crisis in March 2020, the ECB activated this system of easing capital requirements. European banks have therefore no longer been subject to compliance with the P2G buffer since that date. Until this summer, however, there was uncertainty around the timetable for its reintroduction. On 7 July, the President of the Single Supervisory Mechanism (SSM), Andrea Enria, clarified the situation with two new announcements:

  • The Pillar 2 Guidance buffer (P2G) will not need to be reconstituted before the end of 2022.
  • The P2G calculation methodology will now be adapted to take into account the results of the stress tests published on 30 July 2021.

Based on this new methodology for calculating P2G, European banks will now be classified into four categories. The greater the impact on banks during the last stress tests (the theoretical reduction of their capital in the event of an economic and financial crisis), the higher the P2G buffer they will have to build.

Today, the average P2G established by banks represents a wide range between 1.0% and 1.9% of CET1*. This level is closer to 1.0% for systemic banks (G-SIBs), 1.4% for small domestic or commercial banks, and 1.8% for specialized banks or banks focused on professional clients (corporates).

Going forward, the minimum 1% threshold should be removed. The ECB has communicated on the ranges of P2G ratios according to the four categories, as presented below:

However, the calibration of P2G will not be carried out completely mechanically, but will be assessed by the teams in charge of supervision (“Joint Supervision Teams” or JSTs).

We believe that on average, banks will have to build a P2G buffer as follows:

  • 0.75% only for banks with the most solid stress test results (category 1),
  • 1.25% for banks in category 2,
  • 1.75% for category 3,
  • 2.25% for the last banks in category 4.

The 2021 Stress Test was carried out on 50 of the largest banks in the European Union. The number of banks classified in each category, as well as the estimate of the P2G buffer to be established for these institutions, is detailed in the diagram below:

Source : Lazard Frères Gestion, the 7 September 2021

Good news for banks and investors

These recent announcements provide better visibility for the banking sector. The P2G was previously a relatively opaque prudential buffer, both in its calibration by the ECB and in its communication to investors. Banks’ practices in this area could vary, at the risk of being uneven.

The modification of the P2G calculation rules will now provide greater homogeneity between two banks with identical profiles. The four categories will also serve as benchmarks to define the efforts that need to be made to ensure that an institution can progress from one category to another. Clear targets can therefore be established with regard to the NPL ratio, the level of profitability, the capital ratios and the liquidity ratio to be achieved. These criteria will also serve as benchmarks for investors.

With regard to the implementation schedule, it is now assumed that the reintroduction of P2G will not take place before the beginning of 2023. This deadline will allow banks to rebuild their buffer very gradually, which is good news for the banks most affected by the Covid-19 crisis. Thanks to this flexibility, banks will also be able to continue to raise more capital next year to finance the economy and its recovery.

It should be noted that in terms of bank debt securities (senior debt, Tier 2 subordinated debt, and AT1), the measure has no immediate effect as it changes neither the level of risk nor, of course, the credit rating of the institutions concerned. On the other hand, greater transparency will enable investors to carry out certain arbitrage operations in the future by benefitting from more extensive details regarding each institution’s capital structure.

 

* AT1: Additional Tier 1

* CET1: Common Equity Tier 1

Article written on 7 September 2021. The opinion expressed above is dated as of September 2021 and is subject to change. Most recent data at the date of publication. This document has no pre-contractual or contractual value. It is provided to the recipient for information purposes. It contains analyses or descriptions prepared by Lazard Frères Gestion SAS on the basis of general information and historical statistical data from public sources. The opinion expressed above is current as of the date of this document and is subject to change. These elements are provided for information purposes only and do not in any way constitute a guarantee of future performance. These analyses or descriptions may be subject to interpretation depending on the methods used. The analyses and/or descriptions contained in this document should not be construed as advice or recommendations on the part of Lazard Frères Gestion SAS. This document does not constitute a recommendation to buy or sell, nor does it constitute an invitation to invest in the instruments or securities contained herein. Any management method presented in this document does not constitute an exclusive approach and Lazard Frères Gestion SAS reserves the right to use any other method it deems appropriate. These presentations are the intellectual property of Lazard Frères Gestion SAS.
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