Business and risk policy implications of a small banking regime and reformed capital requirements

Preliminary remarks

In our first article “Small banking regime – an initiative by BaFin and the Bundesbank” of the trilogy, we presented the conceptual considerations of the non-paper.

The second article “Reducing regulatory complexity in capital requirements: A solution approach by BaFin and the Bundesbank” dealt with the conceptual considerations for simplifying the normative capital requirements, unbundling the capital and resolution frameworks and simplifications in relation to capital buffers.

In both articles, we initially focused on providing information about the content of the non-papers. Therefore, in the following article, we want to shed light on the business and risk policy implications of these initiatives.

1. Initiative small banking regime (SBR)

Focus on capital management:
More simplicity, less complexity – the normative perspective in transition

From a risk controlling perspective, the small banking regime means a fundamental change of perspective in normative risk management. The previous capital planning, which was strongly driven by risk-weighted assets, is becoming less important. Instead, the leverage ratio takes center stage as the central control parameter – simple, transparent and directly linked to the balance sheet. In future, a single CET1 leverage ratio will form the central capital requirement. This will significantly reduce the previously complex calculation of risk-weighted assets and the complex capital ratio structure with buffer requirements such as CCoB or CCyB. This is intended to make the normative perspective more robust, but at the same time makes it less risk-sensitive.

Focus on pricing:
Margin scope through lower compliance and administrative costs

The Bundesbank’s non-paper on the small banking regime is intended to ease the burden on smaller banks through simplified reporting, governance and disclosure obligations.

This creates margin scope, some of which could be translated into more favorable lending conditions. However, the decisive factor remains how much margin or profit an institution prices in or needs in terms of business policy – depending on competition, market segment and business strategy. While highly competitive areas tend to pass on cost advantages to customers, elsewhere they tend to serve to strengthen equity and profitability.

Focus on sales:
Less administrative effort and reduced complexity

The possible adjustments will allow banks with a traditional business model and lower risks to indirectly benefit from the less complex requirements. Although the proposed framework does not result in any specific simplifications for sales, the less complex regulatory requirements enable banks to reduce the administrative workload of sales staff and thus deploy capacities in a more targeted manner or use free capacities for additional sales activities. The introduction of new products in sales can also benefit from the reduced complexity, as the reduced complexity in regulatory reporting and capital backing can reduce the coordination times between sales, risk management and compliance within the introduction process.

Focus on treasury:
Opportunities and risks

The regulatory adjustments primarily affect risk management and lead to less organizational effort, particularly for smaller institutions. Less complex requirements for liquidity stress tests and simplified reporting formats in the context of RBC and capital planning enable more flexible internal management and can therefore also facilitate refinancing decisions. At the same time, the obligation to ensure sufficient liquidity at all times remains in place. Market perception plays a key role: reduced transparency as a result of simplified internal analyses can potentially lead to higher refinancing costs. Possible facilitations for outsourcing, which could improve access to platforms and enable more favorable refinancing conditions, should be viewed positively.

Focus on regulatory reporting:
From a mountain of data to clarity – How the small banking regime is changing reporting

In the future, numerous risk-weighted templates will be replaced by integrated, simplified reporting that focuses on a few core indicators such as the leverage ratio, liquidity and large exposures. For many institutions, this means a significant reduction in data management, IT processes and validation. The reporting frequency could fall from quarterly to semi-annually, while only key indicators will continue to be reported regularly. This shifts the focus of regulatory reporting from complex risk modeling to transparency, traceability and efficiency – a real paradigm shift for small, non-complex banks. In addition, the introduction of the Integrated Reporting Framework (IReF) at European level will also make things significantly easier for institutions, as both the implementation and acceptance effort will be reduced by providing granular data to the supervisory authority.

2. Initiative to reduce regulatory complexity

Here we examine the effects of a possible realignment of the normative capital adequacy requirements.

Reduction of parallel stacks in own funds requirements

The sum of all own funds requirements (OCR) and expectations (P2G) are currently a conglomerate of capital components:

• TSCR may be met in the structural requirement of Art. 92 CRR, i.e. taking into account defined proportions of AT 1 and supplementary capital T2. The latter can be allocated both in the form of contingency reserves in accordance with Section 340f and via subordinated capital that meets defined requirements.
• In contrast, the capital buffer requirements are expected to be backed by Common Equity Tier 1 capital (Section 10i KWG).
• In its letter on the capital adequacy recommendation, BaFin also expects P2G to be backed by common equity tier 1 capital.

Conversely, this means that:

• Elimination of the recognition of AT1 (typically contingent convertible bonds); use here is only occasionally observed at regional, affiliated institutions.
• Elimination of the recognition of subordinated liabilities as T2: according to our observations, this is regularly used. Elimination would therefore limit the scope for own funds and would have an impact on the institutions’ capital planning
• Elimination of contingency reserves Section 340f as T2: in accordance with Article 62c CRR, contingency reserves of up to 1.25% of the risk-weighted exposure amounts can be taken into account. In relation to the own funds requirements of Pillar 1, this is 18.75%. The elimination of the future possibility of offsetting would therefore mean that the institutions would have to decide on a case-by-case basis, as part of their capital planning, whether to harden their capital by reallocating it to Section 340g reserves, for example.

Depending on the current capital and refinancing structure, this proposal would have an individual impact on the capital planning of a large number of institutions

Unbundling of the capital and resolution framework

According to the considerations, MREL requirements should be defined exclusively as an additional requirement of the resolution framework. This means that CET1 should only be taken into account for the going concern capital framework. AT1, T2 and subordinated eligible liabilities, on the other hand, should only be taken into account for the – additional – MREL requirements under the resolution framework.

According to BaFin (2024), MREL is not an issue for around 96% of institutions because insolvency is envisaged as a resolution strategy for them and therefore no MREL decisions are issued.¹

Simplification of the capital buffer regulation

BaFin and the Bundesbank subsume three considerations under this:

The combination of P2R, P2G and the capital conservation buffer CCoB into a single, “non-releasable” Pillar 2 buffer “P2B”

This proposal has it all: SREP surcharges/P2R are known to be a microprudential instrument of the supervisory authority and must be fulfilled in the capital structure of Art. 92 CRR. Capital buffers, on the other hand, are an instrument of macroprudential supervision to ensure financial stability and must be met with common equity tier 1 capital. Ultimately, the individual amount of P2B should then be determined in the interaction between micro and macroprudential banking supervision.

The second consideration in the context of capital buffers is to combine the systemic risk buffer SyRB and the countercyclical capital buffer CCyB into a single buffer to be released and to allow it to “breathe” with the financial cycle.

Scaling the risk-weighted buffer requirements to the leverage ratio LR using a defined conversion factor

The basic idea is to ensure “synchronization” between risk-weighted and unweighted capital requirements.

The consequence would therefore be an “automated” surcharge on the previous leverage ratio of 3% (Art. 92 CRR). Although the EBA’s SREP guidelines (EBA/GL/2022/03) also provide for leverage ratio surcharges above P2-LR and P2G-LR in line with the risk-weighted capital requirements, we have not seen any concrete observations as to the extent to which these surcharges on the leverage ratio have actually been imposed by the supervisory authorities to date.

The specific effects depend on the individual degree of leverage of the institutions. However, with regard to the capitalization of typical regional banks as we perceive it, the material effects should be manageable.