One of the big support mechanisms for the UK economy during this pandemic has been the availability of grants and corporate loans via the banking system, aided by unlimited liquidity from the central bank.
As a result the size of bank loan books would be expected to rise, while the perceived risks also increase. This has a direct impact on lenders’ risk-weighted assets (RWAs), which in turn impacts their capital ratios, since these are a function of the amount of risk the bank is exposed to.
The UK’s Prudential Regulation Authority (PRA) has just announced a subtle change that helps to alleviate the challenge banks face regarding increased RWAs. Effectively the PRA has said it does not believe RWAs are a good approximation for the evolution of risks captured in Pillar 2A in a stress scenario, and has made an adjustment in an effort to eliminate any increase in Pillar 2 Requirement (P2R). This has the direct effect of helping banks to maintain adequate capital buffers above the critical maximum distribution allowance (MDA), a critical threshold that determines whether a bank can continue to pay dividends, employee bonuses and, crucially, Additional Tier 1 (AT1) coupons.
For 2020 and 2021 the PRA will permit banks to specify their Pillar 2 Requirement value as a nominal amount, rather than a percentage of the RWAs. This means the P2R will not necessarily increase in the event that a bank takes on more corporate loans through this period of economic uncertainty. This should help to protect the wider economy, as the Treasury is requesting.
This adjustment helps to protect the MDA threshold, it helps to protect bank capital (AT1, Tier 2 and equity), gives banks more propensity to lend, and just as importantly shows how coordinated the Bank of England (which houses the PRA) and the Treasury have been in response to this crisis. Many investors will be hoping to see similar adjustments from the European Central Bank before long.