Since the onset of the COVID-19 pandemic, numerous standard-setters around the globe continue to highlight the availability of regulatory buffers for banks to use in times of stress. Such flexibility is one of the key tenets of the Basel standards.

As a result of the Basel reforms, most banking sectors have gradually emerged from the financial crisis better capitalized, better funded, and more liquid. We estimate, for instance, that the capital base of the largest banks has almost doubled over the past 10 years. And it's a similar story for banks' funding and liquidity. As such, public authorities now view their banking systems as conduits for economic and monetary policies, through which they aim to reduce the immediate impact of the economic stop associated with measures to contain the coronavirus. Stronger balance sheets also underpin the resilience of bank ratings in the current context.

Since the onset of the pandemic, however, questions have arisen over banks' ability and willingness to use the regulatory buffers available to them. In November 2016, we stated that, although banks have much stronger capital bases than before the financial crisis, they remain exposed to capital-related confidence shocks (see “Most Banks Don't Need More Capital, But The Flexibility To Use It In Times Of Stress”). At that time, this apparent paradox reflected the risk that higher requirements meant that the distance to regulatory triggers had not increased for many banks despite material capital strengthening (for example, see the below chart "A summary of EU and U.K capital requirements"). It also reflected that higher requirements have also led to a parallel shift in what the market believes are the minimum capital levels banks should permanently respect to keep investor confidence. As a result, in a period of stress, banks might react with many of the same procyclical behaviors that we've seen in the past, such as reigning back new business activity.

A number of developments since 2016 have partly alleviated our concerns, such as clarifications around pillar 2 guidance and requirements in Europe. Recent regulatory developments should also help (see Box below). For instance, we believe that minimum common equity Tier 1 (CET1) requirements for many European banks have typically been reduced by between 1.0%-2.0% on the back of regulatory announcements in the past couple of months. Combined with dividend suspensions or reductions in various regions, these measures have theoretically freed up hundreds of billions of dollars of capital to support additional lending or absorb potential outsized loan loss provisions.

We see the policy and regulatory reaction to COVID-19 as an extraordinary response to extraordinary events. The effect on the real economy is unprecedented in modern times, but, if mitigated, could be short lived--perhaps even more so than the typical contraction and recovery at the end of the business cycle. The policy response to each systemic crisis will not be identical, and the response to this crisis continues to evolve. Nonetheless, as the first global test for the usability of regulatory buffers, it will also help us better understand how the rules will be applied.

Breaches Or Declines In Regulatory Buffers Don't Necessarily Trigger Downgrades

Our credit ratings are forward-looking opinions about credit risk, based on quantitative and qualitative analysis of available information, in accordance with our published criteria (see “Top 10 Investor Questions On Our Ratings Process,” published on June 4, 2020). As such, our ratings on banks--including our assessments of capital and earnings, and funding and liquidity--are not point-in-time but incorporate our expectations of the prospective and sustainable level of relevant metrics. While informed by our view of these prospective metrics, our ratings also incorporate qualitative views of these factors, and are based on a holistic view of how they interact with each other. We therefore don't consider dips in specific metrics to automatically signal weaker balance sheet capacity or more aggressive risk tolerance.

Our Risk-Adjusted Capital framework (RACF) remains the foundation of our capital analysis for most financial institutions globally. We originally introduced the RACF in April 2009, and since then, we have used it to calculate an S&P Global Ratings RAC ratio by comparing our measure of capital--total adjusted capital (TAC)--to the risks a firm takes, as measured by S&P Global Ratings risk-weighted assets (RWAs). We derive RWAs by multiplying a financial institution's main risk exposures by the relevant risk weights (RWs) for various categories of exposure, stated as a percentage.

This approach leaves room for qualitative assessments. The ranges we use to determine our capital and earnings score based on the projected RAC ratio are relatively broad. Like all models, RACF has limitations, particularly in trying to capture a wide range of scenarios while maintaining global consistency. We therefore use other elements of our bank criteria framework to address these. For example, where we see an institution as having unique risks based on information provided, we may determine that this suggests a systematically higher or lower level of losses than our RWs imply. We may address this outcome via adjustments included in our analysis of a bank's risk position.

If a bank breached certain regulatory capital buffers, while still complying with minimum requirements, this would not mechanistically affect the issuer credit rating (ICR). We would consider the following factors in our analysis:

• The reasons underpinning the bank's lower regulatory capital level, for instance whether it is driven by greater activity levels or by hefty credit losses;
• The magnitude and implications of the breach;
• The implications for the current and projected RAC ratios (typically for the next year or two), whether the updated projection leads to a revised capital and earnings score, and the degree of confidence we have behind these projections;
• Our holistic view of the bank's capital and earnings combined with our assessment of its risk position, including peer comparison;
• The overall headroom within the existing rating for some deterioration in capital metrics, with banks that were already borderline before the breach of buffer being more sensitive to a potential negative rating action.

We use our analytical judgement to project RAC ratios, informed by banks' disclosures, including their capital targets, and our discussions with management teams, among other sources. Regulatory updates from local or regional supervisors also guide our projections. In particular, forming a view on the temporary or more durable nature of certain regulatory relief measures may constitute an important part of our projections in certain cases.

We apply a similar logic to our assessment of funding and liquidity. For instance, a liquidity coverage ratio (LCR) falling below 100% would be unlikely to trigger a rating action by itself. The LCR ratio is a rather narrow measure of liquidity, and doesn't typically reflect the considerable secondary liquidity resources available to banks, such as those from central bank initiatives. While we continue to monitor developments, we currently consider it fairly unlikely that bank funding and liquidity would be a source of rating pressure in this stressed period, certainly in a general sense, outside certain developing markets.

Pre-existing Challenges Can Exacerbate The Pressure From Weaker Balance Sheets

If regulatory relief measures were to prove long-lasting and result in a material weakening in banks' capital and liquidity targets, they could lead to durably weaker balance sheets, erode investor confidence, and leave banks less prepared for subsequent stress events. In such a scenario, a weakened prospective capitalization of banks could affect a number of ratings over time, both in developed and emerging markets. Conversely, temporary reductions in capital or liquidity levels, combined with a reasonable degree of confidence around the recovery path, and how banks would rebuild buffers to allow for future stress events, would be unlikely to materially affect banks' ICRs.

Uncertainty over the shape and timing of the economic recovery and pre-existing issues--such as those related to profitability or asset quality--underpin the increase in negative outlooks since late April/early May. We note that about 30% of banks globally now carry a negative outlook (see chart 1, and “How COVID-19 Is Affecting Bank Ratings: June 2020 Update”). A negative outlook typically signals at least a one-in-three chance of a downgrade within the next 24 months for banks rated 'BBB-' or above and within the next 12 months for banks rated below that.

Chart 1

Regulatory Headroom For Hybrid Coupon Payment Benefits From Recent Measures

While the breach of certain regulatory capital buffers may not automatically affect ICRs or senior bond ratings, lower regulatory capital metrics could expose certain subordinated instruments to a higher risk of coupon nonpayment, all else being equal. We don't see hybrid coupon nonpayment as a tool that banks will generally need or want to use in this stressed period, and note that investor reaction to a coupon nonpayment on an additional Tier 1 (AT1) instrument is still largely untested.

However, hybrid coupon nonpayment could become more relevant to banks that face increased, sustained pressure on their creditworthiness, and certain triggers may force management's hand in this respect. Our ratings on hybrid instruments are typically already at least three or four notches lower than the SACPs on banks, depending on the nature of the specific hybrids. That said, we could widen the notching on some instruments over time, most likely in idiosyncratic cases, particularly if we expect the distance to certain triggers (for example, mandatory going-concern triggers) to narrow materially.

The COVID-19 pandemic presents the first true test of regulatory resolution regime enforcement and accounting implementation (for example, IFRS 9, CECL) while under intense systemic stress. It also gives insight into when regulators and banks might use AT1 coupons as a "going-concern" form of loss absorption and capital preservation.

As a result of the wide-ranging regulatory relief measures implemented globally, regulatory headroom for AT1 coupon payment has expanded across Europe and in other regions--based on end-2019 ratios at least--with some actions easing banks' CET1 requirements by 1% or more.

It also seems clear that while a number of regulators have pushed banks hard to cut or defer shareholder distributions, they are not standing in the way of AT1 coupon payments at this time. In our view, this is unsurprising. While banks can stop paying AT1 coupons at any time, and payments will be suspended if banks breach certain capital thresholds, there is no clear regulatory incentive to intervene too early, for the following reasons:

• Coupon cancellation would lead to marginal CET1 preservation at the individual bank level;
• Regulators are trying to solve a real economy crisis, using the banking system as a key conduit for mitigation. Spurring creditor risk aversion toward the banking system contradicts this aim; and
• AT1s are issued to a fixed-income investor base for whom there is no upside risk. While they should, and are available to, absorb losses on a going-concern basis, they would become uninvestable, except at extreme costs, if coupons were stopped too early in a downturn.

A regulator could decide to mandate that all banks stop paying hybrid coupons in order to provide "cover" for a more-stressed bank to stop payments without being singled out for a potential loss of market confidence. However, given the broader impact for market confidence, we would expect regulators to consider possible interventions to address the bank-specific situation first. (We note that a hybrid rating would be lowered to 'D' if a bank stops paying because of a government or regulatory directive to stop coupons [as we saw in the global financial crisis when several banks were required to stop paying coupons by government or European Commission State Aid rulings]. However, this would not result in a lowering of the ICR to 'D' or 'SD'.)

Policy Responses Will Evolve As They Seek To Support Economic Activity While Preserving The Financial System's Soundness

A key priority for public authorities now is to avoid the liquidity stress on the back of the economic stop mutating into a solvency crisis for the real economy. Banks play a critical role in this, and the regulatory reform of the past 10 years has equipped them for the challenge. But, in their efforts to encourage banks to lend, policymakers walk a fine line to ensure that these measures don't compromise the long-term stability of banks, the credibility of the past regulatory overhaul, and the transparency of the financial sector. To date, banks in most systems seem to be responding to public incentives for them to lend. To continue to make informed decisions, banks and investors alike will need both visibility of, and confidence in, the path to regulatory normalization. Maintaining transparency will remain a critical component of policy response in the recovery phase.

Related Research

• How COVID-19 Is Affecting Bank Ratings: June 2020 Update, June 11, 2020
• Top 10 Investor Questions On Our Ratings Process, June 4, 2020
• Europe’s AT1 Market Faces The COVID-19 Test: Bend, Not Break, April 22, 2020
• Risk-Adjusted Capital Framework Methodology, July 21, 2017