In 2016, BaFin began the national implementation of the EBA's guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP). In collaboration with the Deutsche Bundesbank, an individual overall capital requirement was set for 303 of the LSIs, the less significant German institutions, in the same year as the outcome of the SREP.¹

BaFin's general administrative act dated 23 December 2016, the order on capital requirements for interest rate risk in the banking book, applied initially to the approximately 1,200 remaining LSIs for which BaFin had not set an individual overall capital requirement in 2016 as part of the SREP. These institutions were also brought into the SREP capital determination process during 2017. Now that the respective SREP overall capital requirement for individual institutions has become effective, the capital add-on under the general administrative act no longer applies.

Pillar 1 plus approach

The appropriate overall capital requirement for the specific institution is determined in the context of the national implementation of the SREP capital determination using a Pillar 1 plus approach. In addition to the risks already covered by Pillar 1, this includes all other material risks of the particular institution, which are generally quantified by analysing the institution's internal risk measurement and management procedures. The results of the institution's internal procedures for ensuring capital adequacy (internal capital adequacy approaches; ICAAP) therefore play a particularly important role. This ensures that the pronounced heterogeneity of the German banking sector is properly reflected and that the principle of proportionality is observed.

Individual determination of the SREP overall capital requirement

For the purposes of the SREP capital requirement (see Figure 1 "2017 SREP overall capital requirement"), BaFin determines the capital adequacy for each individual institution pursuant to section 10 (3) of the German Banking Act (Kreditwesengesetz). In addition to the existing capital requirement resulting from Pillar 1, which amounts to eight percent of the total risk exposure amount and represents the minimum requirement, a mandatory Pillar 2 add-on is calculated for the particular institution. This represents the total of the capital amounts required to be held for the individual types of risk under Pillar 2. The add-on must comply with the same requirements relating to the quality and composition of capital as apply to the Pillar 1 capital requirements. This means that at least the same proportion of the add-on must be held in the form of Tier 1 capital and/or common equity Tier 1 capital. Moreover, any shortfall will attract the same regulatory consequences for the institution as previously applied for a shortfall in the Pillar 1 requirements.

Interest rate risk in the banking book

The most significant risk for which BaFin had to order a capital add-on for specific institutions in 2017 was interest rate risk in the banking book. In order to quantify the risk, BaFin uses the results of a stress test known as the Basel interest rate shock. The results are determined on the basis of standardised scenarios and the institutions' internal methods and procedures. The SREP capital determinations in 2017 showed that the institutions had to maintain most of their additional own funds to cover interest rate risks principally caused by maturity transformation. The 902 notices issued up to 31 December 2017 showed an average unweighted capital add-on of around 1.13 percentage points for interest rate risks (previous year's average of the final notices: 0.89 percentage points).

According to the notices issued up to 31 December 2017, the capital requirements for all other risks – in addition to the Pillar 1 risks and interest rate risks – were lower than the average value for the smaller comparable group in the previous year with an average add-on of 0.24 percentage points (average of 2016 notices: 0.59 percentage points).

Figure 1: 2017 SREP overall capital requirement, as at 31 December 2017

2017 SREP overall capital requirement

as at 31.12.2017 BaFin

Target equity ratio

In parallel to the SREP overall capital determination, BaFin informs the institutions of their target equity ratio. This is the second component of the Pillar 2 requirements and plays a similar role to the capital conservation buffer required to be maintained in addition to the SREP overall capital requirement. The target equity ratio tells an institution how much additional capital it should maintain from a supervisory point of view, in order to ensure that it is able to comply with the SREP overall capital requirement at all times over the long term and after taking into account potential losses in stress phases.

BaFin derives the target equity ratio from the supervisory stress test, which uses the stress components in the 2017 survey on the low interest rate environment.² This target equity ratio can be offset against the capital conservation buffer of 1.25 percent required to be maintained pursuant to section 10c of the Banking Act (2018: 1.875 percent; 2019: 2.50 percent). A positive net target equity ratio, i.e. an amount of capital in excess of the capital conservation buffer, therefore only arises if the supervisory stress test produces a higher value than the capital conservation buffer. However, a target equity ratio which is lower than the capital conservation buffer does not result in a lower buffer requirement, since the capital conservation buffer is prescribed by law. Both regulatory capital under Article 92 of the CRR and free reserves under section 340f of the German Commercial Code (Handelsgesetzbuch – HGB) can be used to satisfy the net target equity ratio.

Supervisory expectations

In contrast to the SREP capital add-on, the target equity ratio does not represent a strict supervisory requirement but rather an expectation on the part of BaFin. If the target equity ratio is not reached, BaFin reserves the right to step up its supervision, but there is no automatic mechanism for taking supervisory measures. Based on all of the letters sent out up to 31 December 2017, the average target equity ratio amounts to 2.83 percentage points, from which the applicable capital conservation buffer has yet to be deducted. Provided that the capital conservation buffer is higher than the target equity ratio, the target equity ratio is set at zero.

The 2017 SREP overall capital requirement plus the target equity ratio for the German LSIs therefore amounted to an average of 12.2 percent as at 31 December 2017 (see Figure 1 "2017 SREP overall capital requirement"). The initial findings indicate that overall the institutions have sufficient capital resources to cover both the strict capital requirements and the additional capital in accordance with the target equity ratio.

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