EU weighs bank state-debt limits to ease Germany’s risk concerns

Restrictions on banks’ holdings of government debt are under discussion as European Union policy makers try to address German demands for risk reduction before the bloc moves ahead with closer financial ties.

Euro-area sovereign bonds accounted for just over 10 percent of banks’ assets in the currency area, or 2.73 trillion euros ($3 trillion), at the end of 2015, an increase of about 300 billion euros from a year earlier, according to European Central Bank data. And the euro zone is hardly unique.

The mountains of sovereign bonds on banks’ balance sheets are coming under increased scrutiny from regulators around the world because they’re often treated as risk-free for regulatory reporting, holding down capital requirements. Yet the sheer volume of state debt on banks’ books, and its role in many fundamental transactions such as repurchase agreements, will complicate efforts at reform.

“It is clear that currently there is a very special and favorable prudential treatment of sovereigns in the books of banks, and it is being reviewed,” Adam Farkas, executive director of the European Banking Authority, said in an interview. “This is a topic of high importance because of the specific role sovereign paper plays in the day-to-day operation of banks.”

Banking union

One proposal on the table in Europe is a 25 percent limit on the sovereign bonds some banks can hold risk-free as a share of eligible capital, according to two people with knowledge of the deliberations in Brussels. Above that level, banks might face a sliding scale of risk weights that regulators could adjust in a crisis and which could discourage lenders from holding too much of one country’s debt on a regular basis, they said.

This issue has taken on particular significance in Europe because of Germany’s insistence that the 19-nation euro area reduce the risks on lenders’ balance sheets before expanding the so-called banking union. Sovereign debt is on its list of targets. And Germany is not alone.

Jeroen Dijsselbloem, the Dutch finance minister who chairs meetings of his euro-area colleagues, echoed German concerns in December when he said that progress on a proposed common deposit insurance system would have to wait until risks are addressed. “One of them is a high concentration of government debt on the balance sheets of several banks,” he said. That should be dealt with.”

‘Misleading argument’

Allowing a zero risk-weighting for sovereign debt is based on a “misleading argument” and should be reviewed, according to the Bank for International Settlements.

The nascent reform effort is intended to loosen connections between banks and governments that have fueled the euro area’s recent financial crises. At the same time, EU authorities don’t want to threaten hard-won stability by creating conflict with international banking standards on how to treat sovereign debt, the people said.

Two EU task forces will study the issue and report back at mid-year. Finance ministry deputies are weighing the issue privately, while the Dutch-led EU administrative presidency has also commissioned a banking union task force that is slated to make interim findings in March, midway through its six-month term.

‘Sensible way’

Europe’s review will need to be fully aligned with international work on the issue, Farkas said. Some measures already under way, like the leverage ratio, will “bite the sovereigns” because they aren’t risk-sensitive, he said. While “there is no specific policy proposal on the table yet,” regulators are considering “whether there would be a sensible way” of reducing concentrations on the books of specific banks.

“The context of sovereign holdings in bank balance sheets with respect to other policy objectives, such as liquidity requirements and monetary operations, are being considered in a complex way,” Farkas said. “The discussions are not yet in a design phase.”

Basel’s current rules give discretion to regulators to allow banks to treat their government-bond holdings as risk- free. In the EU’s case, banks can rate all debt issued by the bloc’s 28 national governments as risk-free. There are also no limits as to how much a bank can lend to a single sovereign borrower, contrary to how other types of exposures are treated.

Market access

During the financial crisis, balance sheets of banks in countries including Greece, Spain and Portugal were laden with bonds of their individual sovereigns. This served as a bulwark against those countries losing total market access whenever international investors pulled back, while also making it harder to separate the government’s problems from those of the lenders.

Jonathan Hill, the EU’s financial services chief, said the role of sovereign debt on bank balance sheets is a top priority when considering how to press ahead on broader goals. The question of concentration limits on debt holdings “is one of the questions we are going to look at,” Hill said in an interview. “Whether it’s the right thing to do, that will emerge through that process.”

Hill said the EU would be careful to weigh the global effects of any changes.

“I do think that whatever we do, you need to think about in the international context as well as in the European context,” Hill said. “One can obviously see the logic of it, but if you don’t handle it right, the knock-on effects could be considerable.”

[Bloomberg]