SREP capital requirements in 2016

In 2016, based on the national implementation of the EBA Guidelines on common procedures and methodologies for the supervisory review and evaluation process (SREP),¹ BaFin began the process of determining a capital add-on for less significant institutions (LSIs).² This capital requirement – as an addition to the minimum capital requirements under Pillar I of the regulatory framework for banks – relates to those risks that Pillar I (8% of risk-weighted assets) covers only inadequately or not at all. The Pillar I requirement is therefore supplemented by an additional capital requirement: Pillar 1 "plus". It must be complied with just as rigorously as the 8% requirement under Pillar I.

Interest rate risk in the banking book

For the majority of the institutions supervised by BaFin, the most significant risk that is not covered by Pillar I is interest rate risk in the banking book. It is mainly, though not exclusively, determined by the institutions' maturity transformation activities. But there are other risks not found in Pillar I which the banks themselves consider to be material, such as funding risk. However, insolvency risk as a component of liquidity risk is not taken into account in this context since it essentially cannot be backed with capital.

In practice, the institutions had to quantify the additional risks even before the introduction of Pillar I “plus” and back them with capital for risk cover. But this took place in the context of an internal procedure, namely the risk-bearing capacity concept as the German equivalent of the Internal Capital Adequacy Assessment Process (ICAAP). The ICAAP and its future-oriented supplement in the form of capital planning constitute the risk-bearing capacity approach, which BaFin had already scrutinised and assessed in the past but which did not lead to a specific regulatory capital requirement.

The new Pillar I “plus” represents a different approach. The ICAAP remains the starting point for the risk assessment, but BaFin is now required to use this as a basis to set a capital requirement itself and communicate the binding result to the institutions. Only regulatory capital recognised under Pillar I (i.e. Common Equity Tier 1 capital, Tier 1 capital and Tier 2 capital) can be used as risk cover, internal components of capital (e.g. expected profits) cannot be used. The minimum ratio for the mix of types of capital under Pillar I (at least 56% Common Equity Tier 1 capital and at least 75% Tier 1 capital) also applies.

The principal feature of the EBA approach described above is that the calculation of the capital requirement is based on the type of risk, with the exclusion of diversification effects across different types of risk. For the Pillar I risks (credit risk, market risk and operational risk), the CRR capital requirements are compared with the results of the ICAAP and in each case the higher value is used, i.e. at least 8% for the three types of risk. If an institution identifies other material risks in addition to the Pillar I risks, then the resulting capital requirement must be higher than 8%. For this reason, the "plus" really is a plus – only in exceptional cases is an institution likely to have no risks other than those under Pillar I.

Specific considerations for Germany

The great challenge for German supervisors in 2016 was to develop a method of calculating the capital requirement that reflected the particular nature and structure of the German banking sector: starting from the existing qualitative assessment, the objective was to derive risk-oriented capital requirements for a large number of institutions. Here, BaFin benefitted from the principle of proportionality incorporated in the EBA guidelines. This means that it has to notify a capital requirement for less significant institutions only once every three years. This applies for at least as long as their risk situation remains unchanged. BaFin therefore identified an initial 319 institutions in 2016 that were to be the first to receive capital requirements notices.

ICAAP as a basis

In principle, the information from the ICAAP serves as the basis for the quantification of risk. As at 31 December 2015, the institutions were required to submit notifications in accordance with the German Financial and Internal Capital Adequacy Information Regulation (Verordnung zur Einreichung von Finanz- und Risikotragfähigkeitsinformationen) for the first time. The quantification of the other material risks in addition to the Pillar I risks is based directly on these notifications by the institutions. With respect to the interest rate risk in the banking book, however, BaFin carries out its own quantification. Based on the results of the interest rate shock (a parallel shift of 200 basis points in the yield curve) familiar from the Basel framework, it includes only half of the negative change in present value. The quality of the risk management system is taken into account, both for the risks taken from the ICAAP and for the interest rate risk in the banking book. A good sub-rating from the risk profile for the respective risk will generally have the effect of reducing the capital requirement, while a poor rating may increase the capital requirement.

Average SREP overall capital requirement of 9.49%

In 2016, BaFin notified 303 of the total of 319 institutions examined of their capital requirement. On average, the institutions were required to maintain 0.89 percentage points for interest rate risks and 0.59 percentage points for other material risks in addition to the Pillar I requirement. The resulting average SREP overall capital requirement for all of the institutions examined by BaFin in 2016 for the purpose of setting a capital requirement amounted to 9.49%, which was higher or lower in individual cases depending on the institution and the nature of the risks (see Figure 1 "2016 SREP overall capital requirement").

Figure 1 2016 SREP overall capital requirement

2016 SREP overall capital requirement

Source: BaFin

Institutions that were not notified of their capital requirement by BaFin in 2016 are required as from 1 January 2017 to cover at least the interest rate risk quantified by BaFin on the basis of the interest rate shock. The legal basis for this is a general administrative act dated 23 December 2016, which is intended to ensure equal treatment of the institutions for this material type of risk at least with respect to the approach adopted. If one of these institutions receives a SREP overall capital requirement notice which becomes effective, the general administrative act ceases to apply to that institution.

The combined buffer requirement pursuant to section 10i of the German Banking Act (Kreditwesengesetz) must be complied with in addition to the SREP overall capital requirement. However, for the large majority of institutions only the capital conservation buffer pursuant to section 10c of the Banking Act is currently significant.

Target own funds indicator

A similar role to the capital conservation buffer is played by the target own funds indicator which BaFin notified to the institutions for the first time in 2016. It relates to the coverage of risks emerging in periods of stress. BaFin uses the target own funds indicator to notify the institutions about how much additional capital they should maintain from a supervisory point of view in order to ensure that they are able to comply with the SREP overall capital requirement over the long term and after taking into account potential losses in stress phases. BaFin used the findings of its 2015 survey on the low interest rate environment³ as the basis for quantifying the target indicator. Offsetting against the capital conservation buffer is permitted. The institutions may cover the amount of the target own funds indicator in excess of this buffer either with regulatory capital or with free reserves pursuant to section 340f of the German Commercial Code (Handelsgesetzbuch). On the other hand, the capital conservation buffer must always be covered by Common Equity Tier 1 capital.

In general, the target own funds indicator is more of a target or guidance figure: in contrast to the regulatory capital requirements, it does not represent a minimum figure which must be complied with to avoid immediate supervisory measures.

The average target own funds indicator for the 319 institutions examined in 2016 amounted to 1.35%. The target own funds indicator may be offset against the capital conservation buffer (2016: 0.625%; 2017: 1.25%).

Opinion: Raimund Röseler on the German SREP

Minimum requirements vs. the complete picture

Credit risk, market risk and operational risk: these are the three types of risk defined by the Basel Committee on Banking Supervision for a global standard minimum capital requirement of eight percent. However, it is not possible to fit every banking transaction in the world into a model of three types of risk, nor can a single minimum capital requirement adequately reflect the risk characteristics of every individual institution. Such a requirement is precisely what it claims to be: a minimum requirement.

More than 10 years ago, in order to enable supervisors to set institution-specific requirements for all material risks, the Basel Committee created Pillar II as part of Basel II⁴ to supplement the minimum capital requirements, which from that time on formed Pillar I of its regulatory framework. This second pillar is intended to capture all of an institution's risks, including those not addressed by the Pillar I minimum capital requirements. It has also been incorporated into the Banking Act via Brussels.

Pillar I "plus" approach

The cornerstone of Pillar II is the Supervisory Review and Evaluation Process (SREP). While Basel grants supervisors considerable freedom in the choice of supervisory approach for the SREP, in Europe the complete harmonisation of Pillar I by the CRR (Capital Requirements Regulation) has now been followed by the harmonisation of the Pillar II supervisory process on the basis of the guidelines published by the EBA. The Pillar I "plus" approach, which has been applied in the United Kingdom for some time now, has prevailed. It involves supplementing the minimum requirement with an institution-specific regulatory capital requirement, aimed at covering those risks captured only partially or not at all by Pillar I.

The new regulatory capital requirement is made up of both elements – the regulatory minimum capital requirement under Pillar I and the institution-specific capital requirement for risks not addressed by Pillar I.

Risk-based test run

In 2016, BaFin implemented capital requirements on the basis of the SREP for an initial 319 institutions, in what could be called a risk-based test run, to enable it to dedicate the necessary care and attention to each of the total of approximately 1,600 institutions under its direct supervision. The remaining institutions were required to maintain sufficient capital to cover interest rate risks in the banking book in addition to the Pillar I minimum requirements, on the basis of a general administrative act issued by BaFin in December 2016⁵ (see info box "General administrative act"). Further institutions will undergo BaFin's procedure for setting a capital requirement during 2017. The general administrative act will cease to apply when their SREP notices become legally effective. BaFin’s objective is to notify all institutions of their individual regulatory capital requirements as quickly as possible. The experience gained in the first run will form a solid foundation for future procedures and gradually both BaFin and the institutions will be able to develop this into a routine.

Risk-orientation and transparency

BaFin’s approach to setting capital requirements has two guiding principles: risk-orientation and transparency. Risk-orientation calls for a capital requirement which is appropriate to the individual risk, and which takes into consideration the institution's own risk quantification as well as BaFin's assessment. BaFin used the institutions' calculations of risk-bearing capacity for this purpose, which meant that no additional data had to be provided in order to set the SREP capital requirement; it was based solely on data already available.

A point that was and continues to be important for BaFin is that the way in which capital requirements are set should not be a secret. To this end, BaFin presented its methodology in numerous discussions with the institutions and at a major public event in May 2016. In 2016, BaFin commenced the process of setting a capital add-on in the SREP for all of the approximately 1,600 institutions under its direct supervision.⁶ In its notices of hearing to the institutions, it explained the calculation of their individual SREP capital requirements, and gave them the opportunity to review their capital requirements themselves and raise queries about them in exchanges with BaFin.

Balanced approach

BaFin firmly believes that its SREP represents a balanced approach which stands up well to international comparison.

A certain robustness in setting the capital requirement benefits both BaFin and the institutions, because there is no need to adjust the SREP capital add-on for every minor change in risk. The capital requirement is therefore set in incremental steps and does not conform to a linear distribution. Where there are only insignificant changes in the institution's level of risk, in most cases no amendment to the SREP notice is necessary. The capital requirements for the individual steps (which are also called “buckets”) are based on the capital requirement for the lower threshold of the bucket. However, if there is a material and sustained change, whether positive or negative, in an institution's risk position, BaFin will initiate a new SREP – if necessary independently of the three-year cycle which normally applies for smaller institutions.

No replacement for qualitative supervision

The expansion of the capital requirement to include an institution-specific requirement does not replace the existing qualitative supervisory approach under Pillar II, but rather adds a quantitative component, yet a very important one, to it. BaFin will, of course, continue to monitor the institutions' proper management and their internal assessments of risk-bearing capacity. But it remains to be seen what reciprocal effects will emerge between the regulatory SREP capital requirement procedure and the Internal Capital Adequacy Assessment Process. In the ICAAP, the institutions are expected to identify their material types of risk, assess them using their own methods and back them with sufficient capital. Moreover, that capital must also be qualitatively capable of absorbing any losses that occur. What is certain is that supervisory guidance on the evaluation of the institutions' internal risk-bearing capacity concepts will have to be revised, and to achieve this BaFin also aims to work closely with the banking industry. Initial discussions on this subject have already taken place and BaFin will push ahead with the topic in 2017, with the goal of completing the necessary amendment to the guidance as soon as possible.

Strengthening the institutions' resilience

The low interest rate environment, which has already lasted for an unusually long time, continues to create challenges for the banks. Pressure on earnings will intensify further if interest rates do not change in the foreseeable future and remain stuck at historic lows for an even longer period. In its survey on the low interest rate environment in 2015, BaFin simulated a shock scenario that demonstrated possible effects on the institutions' earnings situation. This type of stress test helps BaFin gain a more future-oriented perspective on the robustness of the German banking system, and it will make use of this tool whenever necessary.

The results of the survey on the low interest rate environment are also incorporated into the SREP. However, unlike interest rate risk, they are not reflected in the actual SREP capital requirement but in a target own funds indicator. This functions as a kind of individualised capital conservation buffer and can be offset in the SREP against the capital conservation buffer pursuant to section 10c of the Banking Act, which acts as the minimum level. This is intended to strengthen the institutions' resilience in difficult periods as well.

Further harmonisation of the SREP by the ECB

The EBA's SREP guidelines have harmonised the supervisory process in Europe and have laid down a uniform procedure for determining the additional capital requirement for Pillar II risks. The Single Supervisory Mechanism (SSM), which harmonises the supervision of the largest institutions in the 18 eurozone countries, provides further details of its implementation in practice. While supervision of the most important banks⁷ has been carried out directly by the SSM since 2014, in future the intention is for common supervisory standards to be applied in the supervision of the less significant institutions by national supervisory authorities as well. BaFin is playing a part in efforts to further harmonise regulation and supervision in the EBA and SSM. One of its objectives is to preserve the core elements of approaches that have proven effective in Germany for many years while at the same time guaranteeing high standards of European supervision. To achieve this, BaFin sometimes has to use its powers of persuasion; at other times, however, it must practise the art of balancing different supervisory objectives, but also, in particular, different supervisory cultures within Europe.

Low interest rate environment

In view of the current low interest rate environment and the associated impact on the institutions' earnings, the Bundesbank and BaFin will conduct another survey on the low interest rate environment in 2017. The most recent similar survey from 2015 provided BaFin and the Bundesbank with important information about the earnings capacity and resilience of German institutions. BaFin would like to use the new version of the survey to find out more from the institutions about the performance of various earnings indicators assuming a number of interest rate scenarios.

The survey will also include a stress test covering credit risk, market risk and interest rate risk. With regard to credit risk, the intention is to analyse the institutions' resilience in the event of a deterioration in credit quality and a simultaneous decline in the value of collateral. For market risk, ratings-based increases in credit spreads and negative movements in price for a variety of asset classes are assumed. As far as interest rate risk is concerned, the effect of the Basel standard interest rate shock (a parallel shift of 200 basis points in the yield curve) on different indicators in the institutions' profit and loss accounts will also be assessed.

In principle, BaFin will include all of the institutions under its direct supervision in the survey. However, individual groups of specialist institutions – for example Bausparkassen – will carry out their own stress tests. This will enable BaFin and the Bundesbank to take adequate account of the particular characteristics of the institutions' specific business activities.

The results of the stress tests will be fed back into the target own funds indicator described above. In addition, from the survey it will also be possible to identify negative developments in earnings that are not incorporated directly in the target own funds indicator.

Business models

A central component of a bank's risk profile is the analysis of its business model. The latter's viability and sustainability represent focal points for BaFin. It also monitors whether there are indications that the bank is switching to niche strategies and whether it has taken adequate account of potential changes in the market environment and technological developments in its business and risk strategies. For the purposes of its assessment, BaFin makes particular use of the audit report evaluation, the institution's documentation such as strategic and capital planning, knowledge gained from supervisory interviews and special audits and information from the supervisory reporting system.

When analysing the business model, BaFin concentrates on how income arises and whether it can continue to be generated over the long term. It analyses whether current earnings can remain stable in the future – despite potential structural changes, fierce competition and increasing digitalisation – and how the institutions may need to modify their business models. Risks to earnings are a highly significant topic for the institutions not just because of the persistent low level of interest rates: in reality the level of competition and pressure on costs are increasing as well.

Bases for the analysis

In addition to section 25a of the Banking Act, the bases for the analysis include the EBA's guidelines on the SREP referred to above. The latter contain requirements relating to the key aspects of a comprehensive SREP. BaFin integrated the guidelines into its supervisory processes and procedures in 2016 and aligned its existing procedures for the development of institution-specific risk profiles with the EBA requirements. The business model has come to represent a more important element of an institution's overall risk profile. The findings have resulted in the first reviews of business models by the Deutsche Bundesbank.

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