Banks, regulators, Covid-19 and capital preservation: investors beware?

14 May 2020

Unlike the financial crisis, the Covid-19 pandemic has raised questions about the financial resilience of all types of business.

Banks have not avoided this and the Bank of England (BoE) and the Prudential Regulation Authority (PRA), like the Financial Conduct Authority and other regulators, have been proactive in taking steps to ensure that banks are putting themselves in a position to safeguard their financial well-being. Amongst these are measures designed to preserve the capital of banks, noting that regulation requires banks to maintain minimum amounts of regulatory capital as a condition of their authorisation.

As with the regulatory obligations of banks concerning minimum requirements for own funds and eligible liabilities (MREL), the Covid-19 regulatory measures announced by the BoE and the PRA directly affect many banks. However, those, such as investment funds, who hold investments in banks need to be aware of these changes and the possible impact of these regulatory requirements on those investments.

Capital buffers

A key pillar of the regulatory changes flowing from the 2008 financial crisis was the reinforcement of the regulatory capital rules for UK banks and investment firms and an increase in the powers of intervention for regulatory authorities. The new rules included capital buffer requirements designed to help banks, in times of stress, avoid the need to eat into their regulatory capital.

These capital buffers include:

  • the capital conservation buffer (CCB) – this is designed to ensure that there is a basic capacity to absorb losses across the banking system;
  • the countercyclical capital buffer (CCyB) – like the CCB, this also applies to all banks. This is increased in times when risks are judged to be increasing and can be released, as the Financial Policy Committee (FPC) has done recently, during periods of stress when losses materialise;
  • systemic buffers – these include additional capital buffers imposed on banks deemed to be systemically important either for the global economy (otherwise known as G-SIIs) or for the UK economy. Ring-fenced banks are also required to maintain capital to meet a “systemic risk buffer”; and
  • PRA buffer – this is an amount of capital, confidentially set by the PRA for individual banks, which such banks are required to maintain to absorb losses under a severe stress scenario where the bank is judged to be more at risk of loss.

Covid-19 and capital buffers

On 11 March, the FPC reduced the CCyB, which had been due to reach 2% by December 2020, to 0%. This freed up £23bn of capital. Notably, the FPC stated that it expected that this 0% rate would remain in place for at least 12 months.

The PRA has been increasingly vocal in stating that all elements of the banks’ capital buffers may be used to support the wider economy, including the CCyB but also the CCB, the systemic buffers and the PRA buffer. As reported in the Financial Times, the PRA also encouraged UK banks not to book large loan-loss provisions in Q1 2020 in part to avoid banks’ capital being used up in such provisions.

Liquid assets

The regulatory changes from 2008 also included enhanced liquidity rules to ensure that banks would be better able to meet their debts without the need to rely on capital reserves.

The basic requirement is for a specific level of unencumbered, high-quality liquid assets to meet a bank’s liquidity coverage requirement which is defined as net cash outflows under a stress scenario lasting for 30 days.

Covid-19 and liquid assets

The PRA has indicated that banks are expected to use their liquid assets to support their customers and clients, even if this means that their liquidity (as measured by the liquidity coverage requirement) goes significantly below the level mandated by the regulatory rules.

As is the case with capital buffers, the PRA and the BoE have made it clear that liquidity provisions are there to help the banks support the wider economy.

The cancellation of dividends

Perhaps a more controversial measure for capital preservation is the pressure applied by the PRA on UK-headquartered banks to cancel the payment of outstanding 2019 dividends and the suspension on dividends and share buybacks for the remainder of 2020. As the PRA noted, this was designed to ensure that the banks stand ready to support the wider UK economy throughout 2020.

The spectre of bail-in?

In addition to the capital buffers and liquidity measures, banks are expected to maintain MREL-eligible instruments to meet the bank’s individually set MREL requirement. Generally speaking, these are financial instruments which the BoE (the UK’s Resolution Authority) can use to “bail-in” a bank in the event of severe financial stress.

Bail-in is a form of capital preservation in that, if a bank experiences financial stress, the BoE’s bail-in powers enable it to convert or write-off eligible instruments issued by the bank to meet its MREL requirement. The aim of this is to allow the bank to maintain sufficient capital either to stabilise the bank’s financial position or to enable an orderly wind-down.

This is relevant where investors make their investments via MREL-eligible debt instruments and could therefore be relevant to credit funds (noting, however, that many debt investments are made via unregulated parent entities) with the result that not only does a creditor potentially become an owner, but the value of its holding could be much diminished. This would also be relevant to other shareholders where a conversion of debt to equity could have the effect of diluting their holding.

The BoE and the PRA have recently announced that the MREL requirements for each bank for 2021 will reflect the PRA’s changes to the determination of banks’ “Pillar 2A” capital, which represents the capital requirement imposed by the PRA to address specific risks which the PRA considers have not been fully addressed by the basic Pillar 1 process.

These changes to Pillar 2A capital state that the PRA can now set banks’ Pillar 2A capital as a nominal amount, rather than as a percentage of risk-weighted assets (RWAs). As the PRA acknowledged, this could reduce the Pillar 2A requirement for banks as a share of RWAs, which should hopefully mean that banks do not see increased MREL requirements at this time. However, this does not affect the fact that investors could still realise losses in the event that a bank experiences financial difficulty and the BoE is required to use its bail-in powers in respect of MREL-eligible instruments which have already been issued.

What are the potential issues for investors in UK banks?

It is clearly too early to predict the outcome of the current economic downturn on banks’ balance sheets, liquidity and overall financial viability. However, there are a number of points which investors should be wary of:

  • Once a firm no longer holds sufficient capital to maintain its CCB and CCyB requirements, it will face restrictions on distributions such as dividends and, as noted by the PRA, coupon payments on additional tier 1 instruments (amongst other things).

In its Q&A document, the PRA suggests that these restrictions will remain in force even if, in the current economic crisis, the relevant bank is forced to draw down on capital previously used to meet its CCB and CCyB requirements.

Dividends on banks’ ordinary shares have of course already been suspended for the remainder of 2020. However, if a bank is required to use its CCB and CCyB to absorb losses whilst continuing to provide credit to the wider economy, this may mean that the bank is forced to cease coupon payments on additional tier 1 instruments. This could clearly have a significant, negative impact on investors holding such instruments.

As the PRA has acknowledged, the threshold at which this restriction will apply could be reduced as a share of a bank’s RWAs in the event that the PRA sets a bank’s Pillar 2A requirement as a nominal amount rather than as a percentage of RWAs. Nonetheless, the potential restrictions are still in force and therefore, in a protracted economic crisis, there is a possibility that this threshold could be breached.

  • Regulators have acknowledged that the number of bad loans on banks’ balance sheets will increase. This has also been acknowledged by banks with sharp increases in loan-loss provisions for Q1 2020, which will impact on banks’ profitability. Whilst it appears that banks are currently well-capitalised, in the event of a severe, protracted (“L-shaped”) recession, it is possible that a bank may run into financial difficulty. This could be the case where, for UK banks subject to the ring-fencing rules, the ring-fenced bank is still financially viable but the wider banking group is in financial distress.

In these circumstances, the BoE may be required to make use of its resolution powers and bail-in MREL-eligible instruments, which are typically senior, non-preferred debt. This could include the BoE converting such instruments into equity or writing off the relevant instruments, leading to significant investor losses. As noted above, this could have an impact on shareholders who find that their rights are diluted. In the case of a ring-fenced bank where the wider group is under financial stress, this could result in a scenario where the ring-fenced bank itself remains financially viable but investors in the group holding company take significant losses.

  • Even if the BoE is not required to use its resolution powers, banks will be required to restore both capital and liquidity buffers. The PRA has made clear that it expects these to be restored, albeit the banks will be allowed ‘a sufficient period of time’ to do so.

In determining this time frame, the PRA will consider the individual circumstances of each bank but also the need for the relevant bank to support clients and customers. It would seem, then, that the PRA’s regulatory focus will be on banks and their customers going forward and that, unsurprisingly, the restoration of banks’ capital and liquidity positions will be prioritised once the global economy has begun to recover. Investors then, in particular those holding ordinary shares in the banks, are to some extent ‘at the back of the queue’.