Have European Regulators Just Tightened Financial Conditions?
The ECB published the result of its Supervisory Review and Evaluation Process (SREP) yesterday, which increased the average capital requirements for European banks, and overall, increased the average SREP requirement by approx. 100bps. I am not going to go into too much detail as regarding the breakdown of the capital increase, suffice to say it comes from a mixture of increases to the Pillar 2 Requirement and the various capital buffers that banks now have to adhere to. The capital buffers are a combination of the countercyclical, capital conservation and systemic risk buffers, that have been phased in since 2016 and give regulators macro prudential tools to force the banks to hold more capital in advance of more difficult operating environments.
The overall result of this is that SREP CET1 ratios will increase to approx. 11.5% (when the systemic buffer is included), which is a prudent starting level for any bank in preparation of the end of this current cycle, and is 2-3 times the amount of core capital held by banks at the start of the global financial crisis.
The impact on the banks is fairly clear – they need to either generate more capital to support their lending efforts, or the need to reduce the level of their risk weighted assets. For investors in bank debt, the greater capital levels give more comfort that the banks will be in good shape at the end of the cycle; however, until the banks adjust to the new requirements, the “buffer” over and above their maximum distributable amount (MDA) threshold will be lower and therefore the risk of a coupon being missed on outstanding AT1s is marginally higher – although we argue that many of the strongest banks already have more than sufficient buffer capital built in and this latest directive gives more assurance that systemic risk in the sector is diminishing.
However the main take away for us is that, now that banks need to put more capital against their loans, this change to SREP CET1 requirements amounts to a quasi rate increase, tightening financial conditions for the banks retail and corporate customers, and therefore the biggest impact could well be seen in the broader economy. Ironically, just as the ECB encourages banks to keep lending by launching additional TLTRO programmes, another arm of the ECB is making it more difficult for the same banks to maintain the same level of lending.
The upshot of this is that it helps to keep leverage in check in Europe, particularly relative to the US credit sector, and is another reason that we continue to prefer European credit over the US and continue to find attractive relative value in European banks.
