Unpicking the Basel Bufferati

Sam Woods, Deputy Governor for Prudential Regulation (DGPR), is well known for his analogies. He spoke about the “Prudentist” not too long ago, and even this time he seamlessly transitions from talking about concept cars to the exciting world of capital buffers. 

But, if your role sits within the realm of banking regulation, reading his speech might keep you as engaged as you might expect to be whilst test-driving – as Sam himself calls it – a concept Bentley; and this is despite the name “Basel Bufferati”, which you might associate less with the Bank of England, and more with a chef’s recommendation at a top-tier Italian restaurant.

What is it?

Basel Bufferati sheds light on the Prudential Regulation Authority’s (PRA) planned reforms – specifically on the calculation of capital requirements and classification of capital instruments. It hints at the PRA’s plans for introducing a swathe of radical capital reforms, which is more attuned to the post-crisis period, and the UK’s “independence” of making its own rules.

The key elements of the Basel Bufferati are:

1. A single capital buffer, calibrated to reflect both microprudential and macroprudential risks.
2. A low minimum capital requirement, to maximise the size of the buffer.
3. A ‘ladder of intervention’ based on judgement for firms who enter their buffer – no mechanical triggers and thresholds.
4. The entire buffer potentially releasable in a stress.
5. All requirements met with common equity.
6. A mix of risk-weighted and leverage-based requirements.
7. Stress testing at the centre of how we set capital levels.

What does this mean?

A single buffer but a higher quality of capital instruments

The PRA is considering the introduction of a single, releasable buffer of common equity, sitting above a low minimum requirement. This would be radically different from the current regime – there will be no Pillar 2 buffers; no capital conservation buffers (CCoB), countercyclical capital buffers (CCyB), global systemically important bank (G-SiB), or other systemically important institutions (O-SII) buffers; and also, no more Additional Tier 1 (AT1).

This means that banks will need to hold higher levels of Common Equity Tier 1 (CET1) capital. There are two main ways of doing this – firms can either increase the quantum of their CET1 instruments that fall within the definition of Article 26 of the Capital Requirements Regulation (CRR); or, decrease the size of deductions under Article 36. Both approaches have a number of ramifications.

Increasing the quantum of CET1 instruments:

1. Banks might feel led towards securing funds through the costlier route of equity rather than the comparatively cheaper debt. This will no doubt enhance the loss-absorbing capacity for banks (giving the PRA a better chance to achieve its objective), but banks might have to bear the greater operational and financial burden;
2. They might want to weigh up the merits and demerits of more frequent financial audits, to the extent that realised and unrealised profits can be recognised as CET1 more frequently. This will again be costly – especially for smaller banks – and therefore the question is whether making this proposal for a simpler capital regime is offset by unintended consequences bringing the PRA’s secondary objective of facilitating competition into the spotlight;
3. Banks that meet their current requirements with AT1 or Tier 2 instruments will need to find a way to convert them to CET1 – which again, will be costly.

Alternatively, decreasing the size of deductions to CET1 instruments:

1. Banks might shy away from investing in intangible assets. In that case, there is a question of whether such a strategy – which might be a direct result of central bank policy – would hinder innovation or competition?
2. They might, in general, become more risk-averse – as all losses are fully deductible (without needing a financial audit) and they also increase deferred tax assets – which are also deductible items;
3. Banks might be discouraged from investing in institutions outside the financial sector and/or the banks might raise their interest rates for loans that are sold to such institutions to offset the additional costs that we have previously spoken about. Whether that would be the right outcome during a period of high inflation is anybody’s guess.

There are of course many other things that can be done, but the common denominator here is whether smaller banks can maintain their competitive edge amidst such changes, and how the additional costs of regulatory change fit in with the PRA’s clear intention of making the UK market more attractive. There is also the question of how the UK-EU divergence that the Basel Bufferati might inflict, would influence the supervision of branches.

There is an argument, however, that beyond the initial days of this change, the ongoing cost of compliance can be expected to drop due to the relatively simpler capital structure. This should be attractive to new entrants, and also current market players once they’ve weathered the storm.

Usable buffer counterbalanced by the need for internal capital preservation measures

The Basel Bufferati concept will replace all thresholds, triggers, and cliff-edges with a judgement-based ‘ladder of intervention’. This means that there would be no automatic consequences to dipping into the buffer, or indeed the minimum capital requirements. If that happened, firms would be expected to have a plan to replenish their capital resources. What needs to be in that plan would vary widely depending on the firm-specific and/or macroeconomic circumstances which had led to the firm entering its buffer, including whether some of the buffers had already been released by the authorities.

This means that firms can afford to be more relaxed in their approach to the risk of breaching regulatory limits. This can be seen as a positive step towards making “life” easier for regulated banks (see our article on one of DGPR’s previous speeches here). Banks might need to add supplemental and more granular thresholds (besides regulatory limits). They would need to be clear about the specific actions that might be taken when each of those thresholds is breached; who might be responsible for taking them; and how frequently would the viability of such actions be tested.

More frequent but simpler stress testing

Stress testing will be used to determine capital requirements but it will move away from the current ‘annual cyclical scenario’ approach, where we test banks’ ability to keep their capital levels above a pre-set hurdle rate in a severe but plausible economic downturn. Instead, stress testing under the Basel Bufferati concept will be just as robust, but simpler to run, more frequent, and cover a much wider range of economic outcomes. Ultimately, this migration could mean that the system moves towards standardised risk weights and rely on stress testing to deliver the sophistication which currently comes from the internal ratings-based approach.

Simpler stress tests and the use of the standardised approach can be expected to reduce the cost of regulation on firms and can be seen as another benefit of the concept. However, it might be somewhat offset by the costs of rejigging the stress-testing infrastructure.