European Banks Weigh-Up Government Bond Problem
Rule-makers Have Slammed Europe’s Implementation of Basel Capital Rules
By Paul J. Davies
Jan. 27, 2015 9:06 a.m. ET
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The headquarters of the European Central Bank in Frankfurt, Germany, in December last year. With the ECB now wading into the market for government bonds, Europe’s banks have a big, willing buyer. Photo: Getty Images
The Basel Committee has been checking Europe’s homework and it isn’t pleased. It has told the Continent its banks need more capital to back sovereign risks, just as Europe is writing to its banks to say they need more capital for other risks.
The group that makes bank-capital rules has found a string of problems in the European Union’s writing of new Basel III standards into regulations. The biggest issue lies in the risk-free treatment of the near €2.5 trillion ($2.8 trillion) of government bonds and loans that eurozone banks own. This means they hold zero capital against them.
The realization that the debts of Western governments present a risk of market- and even default-related losses became undeniable during the eurozone crisis of 2011-12. So banks should assign sovereign debts a risk-weighting, which determines how much capital must be held against the assets.
Any debt-related fight between the EU and Greece following its parliamentary election could resurrect fears about sovereign-credit risks.
The U.K., which is in the EU but not the eurozone, already tackled this by requiring banks to hold extra capital against sovereign exposures. Last week it launched a consultation to formalize that.
Elsewhere in the EU, though, banks have more freedom to exclude sovereign debt from internal models that would assign it a risk weighting and capital charge. Assessors from Basel slammed that approach in a report on New Year’s Eve, saying the banks were being given too much freedom in this regard. And this, the Basel team found, resulted in a “material overstatement” of banks’ core capital.
The upshot is the rules will have to be changed. That could saddle eurozone banks with extra capital demands not long after an aggregate €40 billion of equity was raised in 2014 to bolster the sector ahead of stress tests last October.
Eurozone banks hold more than €1 trillion in loans to governments and almost €1.5 trillion in government bonds. Sovereign exposures make up about 9% of all bank assets. Germany’s banks are in line with that average, while Greece’s are below. But in Spain and Italy, sovereign debts make up 13% and 18% of assets respectively.
Banks have enjoyed strong gains on their bond holdings as yields have fallen since 2012.
German bunds saw total returns of more than 10% across all maturities in 2014 alone and Spanish ones saw gains of almost 17%, for example.
Banks might be tempted to sell some of these holdings, sidestepping requirements for additional capital while also crystallizing gains that would add to core equity capital.
If banks keep the bonds, it is difficult to predict exactly what future capital the holdings will require. In the U.K., the highest quality sovereign debt attracts an average 7.4% risk weighting.
So, if all the Eurozone exposure was of the safest sort, it would add €185 billion to banks’ risk weighted assets—leading to the need for almost €20 billion in additional capital.
For Spanish, Italian and Greek banks, their local sovereign debt will attract a much higher capital charge because it is riskier.
Whatever the number, Europe’s banks will want to reshuffle their holdings before the rules change.
And with the European Central Bank now wading into the market for government bonds, they will have a big, willing buyer.
The Basel Committee has been checking Europe’s homework and it isn’t pleased. It has told the Continent its banks need more capital to back sovereign risks, just as Europe is writing to its banks to say they need more capital for other risks.
The group that makes bank-capital rules has found a string of problems in the European Union’s writing of new Basel III standards into regulations. The biggest issue lies in the risk-free treatment of the near €2.5 trillion ($2.8 trillion) of government bonds and loans that eurozone banks own. This means they hold zero capital against them.
The realization that the debts of Western governments present a risk of market- and even default-related losses became undeniable during the eurozone crisis of 2011-12. So banks should assign sovereign debts a risk-weighting, which determines how much capital must be held against the assets.
Any debt-related fight between the EU and Greece following its parliamentary election could resurrect fears about sovereign-credit risks.
The U.K., which is in the EU but not the eurozone, already tackled this by requiring banks to hold extra capital against sovereign exposures. Last week it launched a consultation to formalize that.
Elsewhere in the EU, though, banks have more freedom to exclude sovereign debt from internal models that would assign it a risk weighting and capital charge. Assessors from Basel slammed that approach in a report on New Year’s Eve, saying the banks were being given too much freedom in this regard. And this, the Basel team found, resulted in a “material overstatement” of banks’ core capital.
The upshot is the rules will have to be changed. That could saddle eurozone banks with extra capital demands not long after an aggregate €40 billion of equity was raised in 2014 to bolster the sector ahead of stress tests last October.
Eurozone banks hold more than €1 trillion in loans to governments and almost €1.5 trillion in government bonds. Sovereign exposures make up about 9% of all bank assets. Germany’s banks are in line with that average, while Greece’s are below. But in Spain and Italy, sovereign debts make up 13% and 18% of assets respectively.
Banks have enjoyed strong gains on their bond holdings as yields have fallen since 2012.
German bunds saw total returns of more than 10% across all maturities in 2014 alone and Spanish ones saw gains of almost 17%, for example.
Banks might be tempted to sell some of these holdings, sidestepping requirements for additional capital while also crystallizing gains that would add to core equity capital.
If banks keep the bonds, it is difficult to predict exactly what future capital the holdings will require. In the U.K., the highest quality sovereign debt attracts an average 7.4% risk weighting.
So, if all the Eurozone exposure was of the safest sort, it would add €185 billion to banks’ risk weighted assets—leading to the need for almost €20 billion in additional capital.
For Spanish, Italian and Greek banks, their local sovereign debt will attract a much higher capital charge because it is riskier.
Whatever the number, Europe’s banks will want to reshuffle their holdings before the rules change.
And with the European Central Bank now wading into the market for government bonds, they will have a big, willing buyer.
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