The European Central Bank adapts its own funds and liquidity coverage ratio rules to COVID-19

On 12 March 2020, the ECB announced that it will allow banks to temporarily use capital and liquidity buffers which they have built in past years to enjoy more flexibility during the COVID‑19 crisis. The ECB's reasoning was that such capital and liquidity buffers have been designed to be used in and to withstand a stressed situation like the current one. As to capital buffers, this relates to the capital conservation buffer (CCB). In addition, the ECB encouraged national macroprudential authorities to adjust or release countercyclical capital buffers set by them, and banks were allowed to operate temporarily below the required 100 % minimum liquidity coverage ratio (LCR).

At the same time, the ECB decided that credit institutions may temporarily not comply with the Pillar 2 Guidance (P2G) set by the authorities. P2G indicates the expectation of regulators for a bank's adequate level of capital to withstand stressed scenarios based on supervisory stress tests. Pillar 2 Requirements (P2R) which need to be maintained to cover the risks of a bank's business were relaxed to the effect that institutions need a lower percentage of highest quality own funds, i.e. Common Equity Tier 1 (CET1), and may fill the remaining P2R with Additional Tier 1 and Tier 2 instruments, allowing banks to use the somewhat relaxed rules which would otherwise have come into effect in January 2021.

The ECB measures apply directly to significant institutions supervised by the ECB. However, the Austrian Financial Markets Authority (Finanzmarktaufsichtsbehörde – FMA) informed Austrian credit institutions in a letter to the Austrian Chamber of Commerce on 17 March 2020 that they intend to follow the ECB and EBA rules and recommendations("feel obliged to follow the EBA and ECB recommendations").

As widely reported in the media, in view of the relaxation of own funds rules for banks, the ECB has strongly advised banks to refrain from dividend distributions and share buybacks until further notice. The rationale is that banks should not pay dividends or repay capital to shareholders (even if the financial year 2019 was successful) in a situation where own funds are depleted. Whether this recommendation is appropriate remains controversial. Apart from that, there is a legal requirement to limit distributions to the so-called maximum distributable amount (as defined by EU law), if an institution is operating below the combined buffer requirements. In this case it is not just a recommendation but a legal obligation to limit distributions.

It should also be stressed that capital and liquidity buffers shall mainly be used to balance the effects of COVID‑19, as can been seen from the ECB's press release of 28 July 2020. For this reason, the ECB has also stated that a failure to comply with capital and liquidity buffers will not automatically trigger regulatory action. In other words, if the ECB or a national competent authority should conclude that an institution still needs to replenish its capital and/or liquidity buffers (for example, because non‑compliance is not related to COVID‑19), they may still do so.

In its statements of 28 July 2020, the ECB clarified and specified certain aspects of its supervisory measures in response to the coronavirus, i.e. in its supervision blog and in FAQs. Banks will not be required to start replenishing the capital buffers before the peak in capital depletion will have been reached. This means that compliance with P2G and the combined buffer requirements will not be required any earlier than the end of 2022. As to the LCR, banks will not be required to restore the buffers any earlier than the end of 2021. The ECB's recommendations on limiting dividend payments and share buybacks were revisited in December 2021. On 15 December 2020, the ECB recommended to significant credit institutions to exercise "extreme prudence" when deciding on or paying out dividends or performing share buy-backs until 30 September 2021 (and, in any event, discuss any dividend payment or share buy‑back with the competent regulator). In this context, the ECB generally considers that it would not be prudent for a credit institution to make a distribution or share buy-back in excess of 15 % of accumulated profits for the financial years 2019 and 2020 or 20 basis points CET1 ratio, whichever is lower.

The ECB reiterated that it expects national regulators to apply the same treatment to less significant institutions which are not supervised by the ECB.

These clarifications by the ECB will help banks planning for the next two years.

author: Peter Feyl