As Europe looks for economic growth, a logical focus is a banking system that is the primary funding source for its businesses. Capital requirements are a major constraint on the amount and pricing of such credit, but lowering such requirements is politically difficult. One reform should be incontestable, though, and that is improving the transparency and objectivity of those capital requirements. In sum: an investor in a U.S. bank can predict with confidence what the bank’s capital requirements will be; an investor in an EU bank can only guess.
Overview
A European bank can face ad hoc capital charges from multiple regulators for any of a multitude of reasons. Those charges generally lack any objective basis. There is no concept of cost-benefit analysis with respect to their collective weight or any mechanism to determine whether they overlap.
The EU capital stack includes three transparent requirements but then adds on a panoply of subjective charges – some labeled as requirements and some as buffers, but all effectively binding and non-negotiable.
In terms of transparent requirements, the EU imposes a Basel minimum capital to risk-weighted assets ratio; it imposes a 2.5 percent “capital conservation” charge (which is labeled a buffer but is mandatory); and it imposes a GSIB surcharge.
But below the water line are numerous potential add-ons highly discretionary and in practice unappealable.
First, a Pillar 2 requirement is imposed by the ECB “to cover risks either not fully captured or not captured at all under the Pillar 1 capital requirement.” It is legally binding.
It is also highly subjective. It can be based on any risk the ECB deems material. Although a supervisory methodology exists, it offers little clarity on how qualitative or idiosyncratic risks – such as compliance breaches, governance weaknesses or reporting deficiencies – are converted into measurable capital charges.
Banks have the right to request an internal administrative review of a Pillar 2 requirement, but such appeals are rarely if ever filed.
Second is Pillar 2 “Guidance,” which is a charge assessed by the ECB to “ensure a bank’s resilience under adverse economic scenarios.” Its size is derived largely from the result of a stress test administered by the European Banking Authority; however, the ECB explicitly reserves the right to add further charges (and reportedly exercises it).
Failing to hold the buffer does not have regulatory consequences (e.g., restrictions on capital distributions), yet it is binding in any practical sense, as the ECB expects banks to maintain it. Nonetheless, because the Pillar 2 guidance is not as a legal matter considered part of a bank’s capital requirements, there is apparently no right to appeal the final guidance or the results of the stress test.
Third is an awkwardly titled Other Systemically Important Institution Buffer. It is imposed by national authorities as a “layer of macroprudential capital imposed upon banks deemed systemically important at the national level, but not necessarily globally.” The European Banking Authority provides guidelines for identification and scoring, but there is no clear formula, and the ECB can add a further charge. While labeled as a buffer, it is mandatory.
If an institution is also identified as a a global systemically important institution, only the higher of the GSIB surcharge and the Other Systemically Important Institution buffers applies. As a matter of transparency, however, bank investors do not know which buffer binds – or will bind in the future.
Fourth is the Countercyclical Capital Buffer, which can range from 0 percent to 2.5 percent of risk-weighted assets. National authorities imposed the charge and are required to consult a buffer guide, which is really no guide at all. It identifies deviation of the ratio of credit to GDP from its long-term trend as only a “common starting point in guiding decisions” and states that any other quantitative and qualitative information can affect the charge, including “information that reflects national specificities.” Some member states have published indicators that they might consider, but in all cases have reserved total discretion to set the buffer at any level they choose.
There is no requirement for public comment. There is no right of appeal under EU law, so any appeal would have to be under the laws of the applicable member state. There is no record of any such appeal.
Fifth is a Systemic Risk Buffer imposed by national authorities to “mitigate long-term, structural risks.” A few states have adopted a public methodology for establishing the buffer, but the great majority have not. The European Systemic Risk Board – yet another player in the EU capital regime – identifies three risks that could form the basis of the charge: (1) propagation/amplification of shocks in the financial system; (2) structural characteristics of the banking sector; and (3) changes in the real economy. Obviously, this mandate leaves extraordinary discretion with national authorities.
Because the systemic risk buffer is deemed a macro-prudential regulation, individual banks have no direct right of appeal in EU law.
Sixth are add-ons to a bank’s risk-weighted assets – basically, driving down a bank’s capital ratio by inflating its denominator. The ECB imposes such charges for any internal model deficiencies it identifies. In theory, a bank can appeal the ECB’s decision to the ECB Administrative Board of Review, but according to its own report, the ABoR delivered only 36 opinions over the 10-year period 2014-24 on all subjects; there may well have been none with respect to these add-ons.
A related but even more opaque capital charge – call it Six.5 – arises because regulators have imposed a de facto pre-approval process for capital models. By withholding approval for a model, regulators can force a standardized charge as the default option, thereby significantly increasing the capital requirement for the asset or exposure.
Seventh is a common equity tier 1 deduction imposed by the ECB. The deduction can be used to compensate for valuation adjustments, non-performing loans or software issues, among others. The deduction is binding.
One would think that seven different subjective, opaque and generally unappealable charges would seem to constitute sufficient discretion for EU regulators, but history shows that all the rules can be jettisoned in the event of market upset. During the COVID crisis of 2020, the ECB issued a formal recommendation – that is, a de facto requirement – that Euro-area banks not pay dividends or carry out share buybacks from profits earned in 2019 and 2020, at least until Oct. 1, 2020. The “recommendation” was effective regardless of how much capital a bank held. The ECB then extended the “recommendation” until Jan. 1, 2021. It then extended further until Sept. 20, 2021, with ECB-set payout ratios in place of an outright ban. (The Federal Reserve took a similar but far more limited approach, and some U.S. policymakers have expressed contrition about that decision.)
This episode taught investors in European banks a serious lesson: even if a bank complies with minimum capital requirements plus all the numerous buffers expressly designed to insulate the bank against systemic risk, that bank will nonetheless be prohibited from providing dividend income to investors in the case of systemic stress – that is, at the time that investors most value a stable stream of income.
Magnitude
A May 2025 survey and study conducted by the Global Association of Risk Professionals (GARP) and sponsored by the European Banking Federation quantified the relative size of the various components of the European capital stack as of 2024. The results are remarkable:
With respect to the core requirement for common equity tier 1 capital, the transparent requirements – the Basel CET1 capital requirement minimum, capital conservation buffer and GSIB buffer – composed only $406 billion of a total of $679 billion in European capital requirements in 2024. Furthermore, between 2021 and 2024 the transparent capital requirements remained stable, but the discretionary requirements rose by 59 percent.
Looking Ahead
U.S. regulators are currently finalizing rules that will establish a transparent and largely objective capital stack with only three components. First is a minimum requirement of capital to risk-weighted assets, calculated using a standardized approach for all banks. While the largest banks also use internal models to calculate credit risk, U.S. regulators appear set to eliminate advanced approaches and move solely to the new Basel standardized approaches for credit. Second, for the largest, internationally active banks, a GSIB surcharge is added to the Basel minimum. While the U.S. methodology for that surcharge differs from the Basel methodology, it is fully transparent. The third component of the U.S. capital stack is a stress capital charge; while the methodology is currently opaque in its modeling, the Federal Reserve last year released the models for public comment.[1]
Notably, the U.S. stress test does not attempt to determine the precise cause of the stress and instead focuses on the likely consequences of any major economic or geopolitical stress: declining GDP (reducing net income); rising unemployment (leading to losses on consumer loans); a fall in housing prices (leading to mortgage losses); and a drop in the stock market (with a variety of results). Thus, the U.S. approach differs significantly from that of the EU, where any new perceived risk – e.g., climate, geopolitical, biodiversity – could produce a capital charge.
Mixed messages are emerging from Europe. Last December, the ECB’s High Level Task Force on Simplification gave a sign that reform may be possible. It noted:
The number of elements in the EU’s risk-weighted and leverage ratio capital stack exceeds those foreseen by the Basel standards, potentially causing overlaps and inconsistencies… The variety of capital elements … may decrease transparency and increase uncertainty as market participants face more challenges in assessing the capital framework, the overall level of requirements and the available capital headroom.
In contrast, the Chair of the Supervisory Board of the ECB stated on Nov. 18, 2025, “Over the coming years, our supervisory priorities will focus on banks’ responses to the changes in the external environment, on strengthening banks’ resilience to geopolitical risks and macro-financial uncertainties and on banks’ operational resilience and ICT capabilities.”[2]
Conclusion
Transparency and objectivity of capital requirements provide three major benefits. First, efficient capital planning, as management can make informed, long-term decisions with confidence. Second, analysts and investors know each bank’s capital requirement, which will reduce the bank’s cost of capital and therefore the cost of the funding it provides to the economy. Third, banks do not have to hold large “uncertainty buffers” to guard against an unexpected increase in capital requirements.
As Europe searches for growth, achieving those benefits should be a major goal.
[1] The Federal Reserve may impose a countercyclical capital buffer, but to date has not done so. Furthermore, in contrast to European rules, the Federal Reserve would seek public comment before imposing the charge.
[2] Speech by Claudia Buch, Chair of the Supervisory Board of the ECB, at the press conference on the 2025 SREP results and the supervisory priorities for 2026-28 (18 November 2025), available at https://www.bankingsupervision.europa.eu/press/speeches/date/2025/html/ssm.sp251118~552e92eb92.en.html
