Simplifcation of banking regulations, really?

On Thursday 11^th of December, the ECB issued a set of 17 recommendations to “simplify” bank regulation and supervision. Perhaps unsurprisingly, most investors and analysts are left even more confused. 

In this short note, we summarize what we think are the most significant proposals and their market impact. We also focus more extensively on a possible reform of the AT1 market. If your passion for bank regulation does not match ours and you are more interested in the performance of your AT1 portfolio, we suggest you immediately jump to the AT1 section of this note.

At a recent conference, I asked M. Campa, EBA Chair, if he could name the 13 different capital buffers applicable to EU banks. I was quite impressed to see that he was able to name every single one of them – but he was the only one in a room full of specialists. Simplification does seem in order. The ECB proposes to facilitate 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.

We think this will 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 banks’ managements choose to hold. Covid 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 risks and uncertainties. 

There is 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 do not usually issue securities so the market will not really care.

The 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 rulebook, 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.) We would single out two recommendations: 

• A simplification of the stress tests, which are currently very cumbersome and expensive and usually interest the market for approximately 15 minutes, and 

• A slightly odd suggestion that the ECB should set a goal for the total bank capital outstanding – something we believe is best left to the market.

Make reporting automatic, machine-readable, more frequent and harmonised? Where do we sign?

The coexistence of TLAC and MREL requirements in the EU has always been an anomaly. Both set of rules 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. This sentence has attracted a lot of attention “*ECB'S GUINDOS SAYS PROPOSING TO MAKE AT1 MORE LIKE EQUITY”. 

What does it mean exactly?

The issue that the ECB is trying to solve is not to facilitate the way 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. 

What the ECB (and others have expressed the same view) would want to see is AT1 providing capital relief while the bank is still in operation. Many pundits have suggested that the Credit Suisse debacle was the reason for the AT1 reform, but I believe it was Covid: supervisors were disappointed that banks did not use buffers and did not skip AT1 coupons during that period of extreme stress. 

Two options are considered.

1. Replace AT1 capital by CET1 capital, but the text strongly suggests that the ECB is not a big fan of this option that would send the banking sector 40 years in the past and sharply increase banks’ cost of capital and reduce their lending capacity.

2. Make AT1s riskier – but how? The report does not offer any suggestion.

Should option 2 be adopted (by far the most likely), what would this mean for current AT1 bonds? Mr. De Guindos made it very clear during the 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.

But more specifically, what will happen to the old bonds? Isn’t there a risk that banks keep old AT1 bonds forever as they would still be eligible as capital but cheaper, because of the lower risk? It all depends 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 2 to Basel 3 which lead to incredible investment opportunities by carefully selecting individual securities.

• The simple Solvency 2 / CRR2 approach: set a fixed deadline in 5 or 10 years 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, so I can only offer guesses or intuition. 

• 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 on Thursday was “meh”. This is a reasonable reaction: the ECB recommendations are just that, “recommendations”, which are offered to the European Commission. In turn, the EC will make its own report in 2026, which could translate into legislative proposals that could follow the usual trilogue process and maybe be adopted in 2027 and implemented in 2028 - or probably later. The important CMDI package started in 2022 and is reaching its final legislative stages only now…