by Laura Cox, Lead Partner, and Ian Kelly, Manager, PwC’s Financial Services Risk and Regulatory Centre of Excellence
The financial sector continues to face big changes and challenges in prudential regulation. The new Capital Requirements Directive (CRD IV) and the associated Capital Requirements Regulation (the CRR) came into effect in January 2014, but the journey to full implementation of CRD IV has only just begun. Many banks, building societies, brokers, asset managers (and indeed regulators) are still getting to grips with these complex prudential rules. Firms have not yet felt the full impact of CRD IV on their capital management and treasury functions. Laura Cox and Ian Kelly of PwC’s Financial Services Risk and Regulatory Centre of Excellence take a look at where the industry is now - and what is still to come.
The basic requirement to maintain regulatory capital at least equal to 8% of risk weighted assets hasn’t changed. But firms now have to meet a much bigger proportion of this (4.5% of risk weighted assets) with share capital or reserves. These ‘high quality’ capital resources are referred to as Common Equity Tier 1 (CET1) capital.
Banks may also boost their Tier 1 capital to a certain extent by using contingent capital instruments - so called because they are designed to convert into CET1 capital in a financial emergency. These instruments (sometimes called ‘cocos’) are more costly to service and market than previous debt-capital bonds because investors are exposed to the potential risk of a loss of their capital investment should the conversion occur.
One of the most interesting aspects of the CRD IV roll-out in the UK has been the divergent approaches of the UK regulators, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The PRA prudentially regulates all UK banks, insurers and a small number of systemically important investment firms. The FCA prudentially regulates all non-systemic investment firms, asset managers and brokers.
The true ‘cost-of-capital’ impact of CRD IV has not fully hit banks and large investment firms.
The PRA has decided to require banks to attain an end-point implementation of CRD IV almost immediately. As a result, UK banks are unable to use many the transitional provisions and allowances in CRD IV. Conversely, the FCA has chosen to allow investment firms to benefit from most of the transitional provisions, but the transitional provisions are quite complex. So the FCA’s genuine effort to ease the regulatory impact on investment firms may have inadvertently increased the regulatory complexity and cost for investment firms and asset managers.
The upcoming cost: the buffers…
The true ‘cost-of-capital’ impact of CRD IV has not fully hit banks and large investment firms. This effect will only be felt when the new capital ‘buffer’ requirements are phased in between 2016 and 2019. These buffers are effectively extra capital requirements which apply in addition to the minimum 8% basic capital requirement - and they must be met using expensive, high quality CET1 capital. They are made up of:
- a 2.5% capital conservation buffer, which will apply to all banks;
- a further countercyclical capital buffer, which macro-prudential regulators and central banks can set at a level between 0% and 2.5% depending on economic conditions; and
- systemic risk buffers of between 0% and 2.5%, which are firm specific and depend on the size and complexity of the firm.
In addition, under CRD IV regulators can apply additional capital requirements to a firm in the form of Individual Capital Guidance (ICG). After all these capital requirements are added together, a bank or large investment firm could easily end up with a capital requirement in the region of 10%-15%. At those levels, banks may struggle to remain competitive and to maintain profitability levels that satisfy their investors.
In the UK, the PRA is putting behind-the-scenes pressure on banks to start aiming for these higher ratios already. Indeed, in June 2013 the Bank of England’s Financial Policy Committee recommended that the eight largest UK banks attain a 7% CET1 capital ratio by January 2014. That’s far in excess of the minimum amount required by CRD IV. The PRA has been working with those banks to ensure they reach and maintain that higher ratio.