Public funding of failing banks in the European Union (LBF vol. 19) 2020/2.4.1:2.4.1 Introduction

Public funding of failing banks in the European Union (LBF vol. 19) 2020/2.4.1

2.4.1 Introduction

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This section discusses the regulatory capital requirements that apply to all banks that are established in a Member State. As a result of these requirements, banks are not entirely free in the way they compose the equity and liabilities side of their balance sheet, because they have to maintain a certain ‘regulatory capital’. The regulatory capital (or own funds) of a bank consists of Tier 1 capital (CET 1 and Additional Tier 1) and Tier 2 capital. The requirements for banks in relation to their Tier 1 capital and Tier 2 capital are also referred to as ‘Pillar 1 requirements’ (see section 2.4.2). In addition to these Pillar 1 requirements, banks are faced with the combined buffer requirement (i.e. the combination of various buffer require ments related to certain risks applicable to all banks or a subset of banks) to address macro-prudential risks1 (see section 2.4.3) and with the ‘Pillar 2 requirement’ (see section 2.4.4).2 Lastly, banks also have to calculate their leverage ratio, liquidity coverage ratio and net stable funding ratio as a result of Basel III (see sections 2.4.5 and 2.4.6).

The below figure gives an overview of the regulatory capital requirements that a bank can be faced with under CRR and CRD IV (except for the leverage and liquidity ratios).3

Figure 2: Regulatory capital requirements applicable to a bank under CRR and CRD IV

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Source: Berger, Hüttl and Merler Bruegel Policy Contribution 2016, p. 12.

The percentages in the shown figure are expressed as a percentage of the total risk exposure amount (TREA). The TREA is not the same as the total liabilities and own funds of a bank. The TREA is calculated in accordance with Article 92(3) and (4) CRR and is the sum of:

a)

the risk-weighted exposure amounts4 for credit and dilution risk5 and counterparty credit risk6; and

b)

the own funds requirements for market risk,7 credit valuation adjustment risk for OTC derivatives8 and operational risk.9

Please see the figure below for the average ratio of TREA to total liabilities and own funds of a bank by bank size category in 2015. Depending on the bank size, this ratio differs between 32.9% (for large banks) and 62.4% (for small banks). The actual impact of the regulatory requirements on the equity that should be maintained in accordance with the regulatory requirements therefore differs depending on the size of the bank. For small banks the regulatory requirements are, ceteris paribus, heavier than for large banks, because the average ratio of TREA to total liabilities and own funds is larger for small banks.10

Figure 3: Average ratio of TREA to total liabilities and own funds of a bank by bank size category

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Source: Berger, Hüttl and Merler Bruegel Policy Contribution 2016, p. 5.

The regulatory capital requirements are further discussed in the following sections.

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