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06 February 2017

ECFIN: Bank Lending Constraints in the Euro Area

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This paper assesses the lending constraints faced by the banking sectors of euro area Member States arising from a combination of low profitability, adverse bank equity markets and the phase in of new capital requirements.

Several capital buffers contemplated in the fourth Capital Requirements Directive and Regulation
(CRR/CRD IV) (8) are being phased in from the 1st of January 2016 to the 1st of January 2019
affecting both systemic and non-systemic bank institutions. All EU banking sectors are rogressively being subject to the introduction of a capital conservation buffer (CCoB), while some supervisors are also discretionarily introducing countercyclical capital buffers (CCyB), which are determined based on a reading of the estimated credit-to-GDP gap (see Graph 2.1 for recent estimates). Additionally, bank institutions that are deemed systemic (9) due to their size and degree of interconnectedness are progressively having to comply with the maximum of three possible capital buffers: the global systemically important institutions (G-SII) buffer, the other systemically important institutions (O-SII) buffer and the systemic risk buffer (SRB). The table in Annex 3 describes these buffers, their legal basis, their possible magnitude in terms of the impact on the CET1 ratio and their introduction profile, including the analytical assumptions used in the calculations shown in this paper.
The combined effect of these buffers derived from aggregating country estimates suggests that they could lead to an increase in the minimum EA CET1 ratio of 2.6 pps by 2019 from the levels
registered at the beginning of 2016 (Graph 2.2). Annex 2 presents, for each EA Member State, the
projected evolution of the minimum capital requirements for systemic and non-systemic institutions, as well as an aggregate country figure based on the relative sizes of the two subsectors for that particular Member State. The detailed data underlying the projected paths are shown in the tables in Annex 4. It should be noted that the calculations were produced at Member State level and aggregated to obtain the EA figures shown in Graph 2.2. A more precise approach would, however, require that the calculation of minimum requirements be carried out at bank level, and aggregated on an institutional basis.
Besides the buffers contemplated in the CRR/CRD, other regulatory developments could drive a
further increase in capital requirements. In particular, the fundamental review of the trading book
(FRTB) and the introduction of a leverage ratio could increase the minimum CET1 ratio by some
0.5 pps. The FRTB would impose constraints on banks' use of internal risk models, increasing
risk-weights and thereby RWA (10). The leverage ratio would impose a limit of 3% on the Tier 1 to total exposure ratio. 
Increases in minimum capital requirements may not generate a significant reaction if they have
been anticipated and sufficient bank capital is already in place in order to meet them. Evidence
suggests this is largely the case for some of the capital buffers and transitional arrangements
contemplated in the CRR/CRD. The most recent analysis carried out by the EBA on the implementation of the CRR/CRD IV (13) based on a sample covering 18 EU Member States and excluding macro-prudential discretions which are explicitly taken into account in this paper (e.g., the systemic risk and countercyclical buffers) and other supervisory considerations (e.g., Pillar II capital add-ons) concludes that "on average, European banks largely fulfil the future regulatory capital requirements, while only a very small number of banks exhibit potential capital shortfalls."
In fact, EU banks have mostly anticipated the end of the transitional arrangements (which will result, inter alia, in the full phase-in of certain deductions and the full phase-out of some eligible capital elements), as shown in the narrowing of the difference between "full implementation" and current capital ratios depicted in Graph 3.1. Additionally, the full phase-in of target requirements reveals only a marginal shortfall as of year-end 2015, after a period of rapid narrowing of expected capital gaps (see Graph 3.2).
However, there are currently several regulatory initiatives not yet enshrined in regulation with the
potential to increase minimum capital requirements. This is the case of the non-buffer measures
described in the lower half of the table in Annex 3 and, in particular, of the leverage ratio and the FRTB. Banks are likely to react to some of these measures, both directly, when their introduction is highly expected, and for precautionary reasons, where their introduction and impact is less certain. Most banks possess significant excess capital buffers (defined as the difference between current capital levels and current regulatory minima) which are due to the anticipation of the phase-in of new buffers between 2016 and 2019, as well as to banks' strategy of maintaining a safety margin over minimum requirements which, in turn, is linked to the degree of market pressure experienced by banks as well as to the volatility in their RoE and RWA. As these CRR/CRD buffers are progressively introduced, excess capital levels are expected to decline. However, other measures may revive pressure for capital build-up. In particular, the leverage ratio is assessed by EBA as a stronger constraint than the Tier 1-to-RWA ratio for around one third of the 246 credit institutions in their analysis, with approximately 9% of them showing a leverage ratio below the required 3% by mid-2015 (14).
Even apparently moderate increases in target CET1 ratios can significantly constrain lending
dynamics in the current low-profitability, low-issuance context. Under the stylized approach described in this paper, EA banks could increase loans on average by 4.4% per year over the 2016-18 period in the absence of increases in the target CET1 ratio. In this case, loan growth would mainly be constrained by the relatively low profitability profile of EA banks. However, when a target increase of 0.5 pps in the aggregate CET1 ratio is to be reached by the 1st of January 2019 (the second scenario), the average loan growth figure drops to 3.1%. If this target increase is raised to 1.5 pps (the third scenario), maximum loan growth rates drop quickly to an average of 0.6% per year. These dynamics are shown in Graph 4.1. The observed acceleration in loan growth in 2018 is the result of the assumed increase in RoE over time and, more decisively, of the fact that the new leverage ratio requirements are assumed to be met over the 2016-17 period.
These results are consistent with the literature estimating the impact of transitioning to higher
capital ratios, where a 1 pp increase in capital requirements can be associated with a 5 to 8 pps
contraction in lending volumes over the short term. See Dagher et al (2016) and the table in Annex 6 for a review of studies estimating the cost of transitioning to higher capital ratios. Also, the literature review in European Central Bank (2015) provides estimated impacts of a 1 pp increase in capital requirements ranging from a 1.4% to a 8.4% decrease in bank lending volumes over the first year (15). It should be noted that the low-profitability context embedded in this paper's approach would be consistent with an impact in the higher range of the results distribution found in the literature.
Cross-country dynamics are diverse, ranging from cases of relatively strong loan growth under all
scenarios to cases of negative growth in 2016 and 2017. The country-specific profiles of EA Member States are shown in Annex 5. The differences in these profiles arise from differences with respect to profitability and to the path for the evolution of minimum capital requirements. The latter affects, in particular, the 1.5 pps CET1 increase scenario, where a reaction to time-varying requirements is considered. The countries with the most unfavourable loan dynamics under this scenario are those recovering from negative RoEs (e.g., Greece, Portugal and Cyprus) and also some larger Member States whose banking sectors are more highly leveraged and therefore potentially more affected by the introduction of the leverage ratio. This is the case of, e.g., France, the Netherlands and, particularly, Germany, where the challenges are compounded by low profitability levels. Contrastingly, lending dynamics appear strong and resilient to different scenarios in countries benefiting from a combination of high profits, low leverage, frontloading of capital buffers already by the beginning of 2016 and relevant non-systemic banking sectors (for instance, the Baltic countries and Luxembourg). [...]


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