The Pillar 2 Guidance is a bank-specific recommendation that indicates the level of capital that the ECB expects banks to maintain in addition to their binding capital requirements. It serves as a buffer for banks to withstand stress.
The P2G is determined as part of the Supervisory Review and Evaluation Process (SREP). Unlike the Pillar 2 Requirement, the Pillar 2 Guidance is not legally binding.
As of 2021, ECB Banking Supervision uses a two-step bucketing approach to determine banks’ individual P2G levels. This new methodology is based on new EU law (the Capital Requirements Directive – CRD V) and input from the European Banking Authority. It ensures a level playing field, improves consistency and reflects the specificities of each bank when setting the P2G level, while remaining simple in its design.
The basis for determining banks’ P2G levels is how banks perform in the regular EU-wide stress tests, which examine the impact an economic shock would have on banks’ capital ratios (i.e. their level of capital relative to their risk-weighted assets).
Our supervisors follow a two-step methodology:
Buckets with P2G ranges (2021)
*maximum P2G in 2021 is expected to be 4.5%
Source: ECB Banking Supervision
The bucketing approach establishes a clear link between P2G levels and the stress test results. Yet, the P2G is not equal to the depletion in banks’ capital ratios, as shown in the graph above. This means, for example, that a bank with an 8 percentage point decrease in its capital ratio will be placed in the third bucket and will thus likely have a P2G of no more than 2.75%. The new methodology also removes the floors that were applied to the P2G in past SREP cycles.
The revision of the methodology does not affect the ECB’s commitment to allowing banks to operate below the P2G and the combined buffer requirement until at least the end of 2022. The ECB intends to give banks sufficient time to replenish their capital if P2G levels are increased. The ECB granted this capital relief measure in 2020 to enable banks to absorb losses and support the economy by providing credit to households, small businesses and corporates.
For banks that were not part of the 2021 stress test, ECB supervisors determine the P2G based on a forward-looking assessment of the bank’s resilience and the potential impact of adverse scenarios on the bank’s solvency.