Strong and Simple – Capital insights from international regimes for simpler firms

Given that the UK has yet to finalise the capital requirements for its own proportionate prudential regime for smaller banks, the Strong & Simple (S&S) regime, we have reviewed the regulatory regime for smaller banks in the USA, Switzerland, China and Australia to provide this insight. 

Among the key approaches taken by international regimes, we have identified which changes may be reflected in the S&S proposals.

Both the United States and Switzerland include exemptions for the countercyclical buffer (CCyB) within their smaller bank regime. This allows smaller firms to deploy more capital, thereby increasing competitiveness by reducing the cost of capital. Currently, in the UK, the CCyB is 2% of risk-weighted assets (RWAs). This is a sizable capital burden on firms (equivalent to 25% of Pillar 1).

The entire design of the CCyB is to counter procyclicality in the financial system by ensuring that banks build up capital in the good times and release it in the bad times. The idea is that this will help stimulate the economy during demand shocks. But the individual contribution that smaller firms, with tiny balance sheets, have when their CCyB’s are released is limited at best. The systematic and idiosyncratic impact of these smaller firms is small compared to the likes of HSBC and Lloyds. Therefore, why bother with making smaller firms hold a CCyB in the first place?

This type of argument is already being made inside the Bank of England. Senior Bank of England officials like Vicky Saporta (summary of her speech on Liquidity Buffers) and Sam Woods (our analysis of Basel Bufferati) have gone public and highlighted a willingness by the regulatory authorities to consider changes in the composition of capital buffers. As a result, we think there is a good chance that the Countercyclical Buffer will be removed for S&S firms.

The jurisdictions that we have analysed in this article have unanimously mentioned the use of risk-weighted assets for calculating capital requirements, with some looking to simplify arduous calculations thereby reducing costs for smaller firms with fewer resources. The risk weight changes can impact firms differently depending on their business model, as certain products will be given preferential treatment over others. Each firm will need to assess the potential impact of the S&S regime when capital changes are released. The Swiss take the most radical approach, with an elimination of risk weights entirely and a focus purely on leverage ratio. However, this is likely to be too extreme for the PRA. Likewise, the Chinese authorities focus on ensuring that domestic loan exposures receive preferential capital treatment, which the UK regulator might find to be on the more interventionist side, which they will look to avoid.

Looking further into the capital stack and Pillar 2, we note that Australia has been used as a template by UK regulators in the recent past. The 'twin-peaks' model, which separates the conduct and prudential regulators, established after the Global Financial Crisis of 2008, closely replicates the Australian model. Their regulatory regime chimes with some of the elements within the capital framework which have long frustrated smaller firms. The Australian regulators were quicker to act, eliminating these frustrations for smaller firms such as credit concentration risk which simpler firms are exempted from under the Australian regulator.

Our view is that the current calculation of credit concentration risk is inadequate. For example, firms with exclusively domestic loan books (which is a large majority of Strong and Simple firms) are often handed a large geographic risk-weight add-on which can contribute up to 1% RWAs to their Transitional Capital Regime. Given the precedent established by the Australians, this could well be something the UK regulators look to refine or even do away with entirely, under a more proportionate regime.

Finally, the UK is introducing a new calculation for Pillar 1 operational risk under the forthcoming Basel 3.1 framework. The business indicator component (BIC) is a measure of firm size and economic activity, and the internal loss multiplier (ILM) measures the sensitivity to firms’ operational loss history. The PRA has mentioned neutralising the impact of the ILM by setting it to 1 during the Basel transitional period. This could be implemented for S&S firms on a permanent basis giving them a small capital advantage over more sophisticated institutions.