In September 2019, the results of the LSI stress test had already revealed the weak profitability of Germany’s small and medium-sized banks and savings banks (less significant institutions, or LSIs) (see October 2019 edition of BaFinJournal – only available in German). BaFin has now used the risks identified in the stress test as the basis for calculating Pillar 2 Capital Guidance (P2G) for each institution for 2019. This guidance has been provided to the banks and savings banks concerned, resulting in around 30 institutions receiving official notification that the amount of capital they hold is below the individual capital guidance level set by BaFin.

The capital that each institution should hold in BaFin’s view in order to meet the P2G has risen on average by around 24 percent compared with 2017. A previous stress test was conducted at that time, which – despite being differently structured – also served to simulate the impact of a major economic downswing on the own funds of credit institutions. Since the stress effect was more severe in 2019 than in 2017, the P2G has also increased.

New calculation method

After informing the institutions of BaFin’s Pillar 2 Capital Guidance for the first time in 2017, BaFin has now revised its calculation method. The 2019 P2G now reflects the stress test results proportionally, with only 65 percent of the stress effect being included in the P2G. By so doing, BaFin has ensured that risks are not overstated in the P2G in certain cases. This is because the stress test does not take into account how management may react to new economic conditions, for example.

BaFin has not made any changes to the maximum limit for the P2G, which remains at 10 percent of the total risk exposure amount. In this way, BaFin caps any outliers, among other things, that could result from features specific to an institution.

CET1 capital required

In order to be able to absorb losses in ongoing operations immediately when they occur, the P2G must be made up of Common Equity Tier 1 (CET1) capital. Only CET1 capital displays specific characteristics that are essential for P2G purposes: for example, CET1 capital is the highest quality form of capital and it does not need to be converted before it can be used. The fact that BaFin has established that only CET1 capital may be used for P2G purposes is in line with the practices of the European Central Bank and the supervisory authorities of other eurozone countries. It also corresponds to the requirements set out by the European Banking Authority (EBA).

What is the P2G?

The P2G is part of the Supervisory Review and Evaluation Process (SREP) (see Figure 1 “Average Capital Requirements and P2G 2019”). In this system, the P2G functions as a buffer that absorbs any losses first and is designed to ensure that an institution is still able to comply with the minimum capital requirements under Pillars 1 and 2, even in times of stress.

Figure 1: Pillar 2 Capital Guidance (P2G) less capital conservation buffer at individual institution level

BaFin

Legal consequences if an institution fails to meet P2G

The P2G thus serves as a valuable early warning system for supervisors. However, as it is a non-binding target, supervisory measures are not automatically taken if an institution does not meet the benchmark. Likewise, the P2G deficit does not automatically restrict distributions to shareholders and managers (Maximum Distributable Amount, or MDA) in accordance with the European Capital Requirements Directive IV (CRD IV). Nevertheless, BaFin subjects institutions that are particularly vulnerable to even closer supervision from an early stage, thereby further strengthening and stabilising the German banking market.