Reducing regulatory complexity in capital requirements: A solution approach by BaFin and the Bundesbank
Regulatory requirements for banks have increased significantly since the financial crisis, leading to greater complexity and conflicting objectives. BaFin and the Bundesbank are proposing reforms to simplify capital requirements and increase the effectiveness of regulation.
Introduction: Why less can be more
The regulatory reforms following the global financial crisis have significantly increased the resilience of the banking system. However, the introduction of numerous parallel requirements – both horizontally (multiple regulatory areas) and vertically (multiple levels within one area) – has greatly increased complexity. Regulatory complexity arises from the fact that the regulatory strands are developed largely independently of each other and each pursue specific objectives from different perspectives. These overlaps not only make implementation more difficult, but can also undermine the effectiveness of regulation.
The supervisory authority has recognized this and has presented possible solutions for discussion in a non-paper, which is considered an informal test of acceptance by market participants. Having already dealt with the non-paper “A Simple Regulatory Regime for Small and Non-Complex EU Banks” (read the first blog post “Small-Banking Regime – an initiative by BaFin and Bundesbank” in the trilogy), in this article we look at the second non-paper from the supervisory authority on the topic of “Reducing regulatory complexity”.
The proposed simplifications are primarily aimed at Significant Institutions (SIs). These are the focus of attention because they are particularly affected by the numerous parallel capital requirements due to their size, complexity and systemic importance.
The current capital architecture: a complex network
Large banks must currently fulfill at least eight parallel requirements resulting from capital and resolution regulations.
Within these “stacks”, there are in turn several levels with different consequences in the event of non-compliance. The capital requirements include CET1, AT1 and Tier 2 as well as various buffers such as the capital conservation buffer (CCoB), systemic buffers (G-/O-SII) and the countercyclical capital buffer (CCyB). In addition, there are requirements from the MREL regime, which contains both risk-weighted and unweighted requirements.
The challenge: interactions and conflicting objectives
The multitude of requirements leads to overlaps and conflicting objectives. For example, a strict leverage ratio can limit the usability of risk-weighted capital buffers. The parallel use of capital to meet MREL and capital requirements can also undermine the effectiveness of the buffers. In addition, the large number of capital types (CET1, AT1, T2) makes transparency and planning more difficult for banks and supervisory authorities.
Proposals for simplification: Three key reform approaches
1. Concentration on CET1 in the capital framework
The authors propose allowing only CET1 as eligible capital in the capital framework. This would halve the number of parallel requirements and improve the loss-absorbing capacity in ongoing business. AT1 and T2 would then no longer have a role in the capital framework, but would be used exclusively in the resolution framework.
2. Unbundling of capital and resolution framework
In future, MREL is to be met exclusively with instruments that are not CET1 – i.e. AT1, T2 and subordinated liabilities. This will prevent capital buffers from being blocked by requirements from the resolution regime. This clear separation increases the usability of the buffers and strengthens stability in the event of a crisis.
3. Simplification of the buffer structure
The authors suggest combining the various buffers (P2R, P2G, CCoB, G-/O-SII) into a non-releasable buffer (P2B). In addition, SyRB and CCyB should be combined to form a releasable buffer. All risk-weighted requirements could be converted into unweighted requirements using a fixed conversion factor, thereby increasing transparency and comparability.
Conclusion: Less complexity, more effectiveness
The proposed reforms would significantly reduce the number of regulatory "stacks" and levels.
Only four instead of eight requirements would be relevant for significant institutions and only two for smaller institutions. Capital planning would be simplified, buffers would be easier to use and regulatory effectiveness would be more effective. However, it is important that these proposals are implemented as an integrated package – only then will they be fully effective.
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