OREANDA-NEWS. If the results of the EU-wide bank stress test to be published tomorrow lead the supervisors to guide certain banks to hold additional capital above their current combined buffer requirements, this should not result in any immediate restrictions on the banks' ability to service additional tier 1 (AT1) capital instruments, says Fitch Ratings.

This is because any 'capital guidance' arising from potential stress test shortfalls will not be included in banks' maximum distributable amount (MDA) calculations, as highlighted in a statement made by the European Banking Authority (EBA) on 1 July. For euro area banks, this was confirmed by the European Central Bank on 26 July, in a briefing ahead of the stress test results. MDAs, laid out in the EU's Capital Requirements Directive, set a limit on the amount of profits that banks can pay out on common equity tier 1 capital instruments, AT1s, bonuses and discretionary pension contributions.

The EBA's stress test is designed to help regulators assess banks' total capital requirements. Since January 2016, EU bank regulators have used common procedures and methodologies to conduct their supervisory review and evaluation process (SREP); SREPs are used to determine a bank's total SREP capital requirement (TSCR).

If the tests show that banks might breach their TSCR under a stressed scenario during the period covered by the stress test (2016 - 2108), provided there is no risk of an imminent TSCR breach, regulators can provide capital guidance and impose tougher capital requirements. They can ask banks to revise their capital plans and suspend dividend payments, for example. However, the EBA also leaves open the possibility of regulators revisiting banks' SREP assessments and TSCR in the event of an imminent TSCR breach.

On 26 July, the ECB confirmed that the pillar 2 capital buffer within euro area banks' SREP will be split into a 'pillar 2 requirement' (P2R) and 'pillar 2 guidance' (P2G) for the 2016 SREP process. P2R will be relevant for a bank's MDA calculation and thus AT1 coupon payments, but P2G will sit above a bank's MDA trigger point and thus not be relevant for AT1 coupons.

Excluding any capital guidance (or P2G for euro area banks) amounts from MDA calculations will make it easier for banks to pay AT1 coupons. This should support the development of this market, which would be positive for capital planning for those EU banks that still need to build up regulatory capital buffers and need to issue securities that could be used for bail-ins.

The EBA is keen to maintain an element of flexibility in AT1 coupon restrictions; for example, earlier this year, it advised the European Commission to revisit the blanket prohibition of AT1 coupon payments if a bank reports a loss. But it also said that a breach of both Pillar 1 and Pillar 2 CET1 capital requirements, plus buffer requirements, would trigger non-payment of discretionary payments, such as AT1 coupons.

Once stress test results are published, it will be up to national regulators to issue specific pillar 2 disclosure guidelines. We expect banks under the direct supervision of the ECB to disclose updated P2R in late 2016. Greater visibility on when AT1 payments might be interrupted should, in our view, bolster investor confidence in the market.

The 2016 EBA stress test includes 51 banks, all of which have assets in excess of EUR30bn. The EBA says this sample represents 70% of the EU's banking sector.