UPDATE 1-Global bank watchdog to review rule on zero-risk weighting for sovereign debt

(Adds comment, background)

LONDON, Jan 23 (Reuters) - Global banking supervisors are reviewing a rule that allows banks to hold little or no capital against risky sovereign debt held on their books.

The so-called zero-risk weighting rule was heavily criticised during the euro zone debt crisis when several countries in the single currency area had to be bailed out.

Even though the ratings on these countries’ debt sank to junk status in some cases, banks were allowed to hold little or no capital.

The rule requires banks to hold capital commensurate with the underlying credit risk but European regulators allow banks to hold no capital against debt held in their currency.

The reasoning is that a country can always print money to pay interest on its debt even when in trouble, though this is not possible for euro zone countries, including Greece and Ireland who had to be rescued.

The euro zone debt crisis triggered calls for a review of the global rule written by the Basel Committee of banking supervisors, but the issue had been too politically sensitive to tackle until now.

“The Committee has initiated a review of the existing regulatory treatment of sovereign risk and will consider potential policy options,” the Basel Committee said in a statement on Friday.

“The review will be conducted in a careful, holistic and gradual manner.” No time frame was given.

Hard-pressed national treasuries like the existing rule because it encourages banks to buy their debt, and some countries fear that change would mean a two-tier debt market emerging as lenders opt for low-risk bonds like German Bunds to save on capital requirements.

Capital on debt at a time of record low interest rates could encourage banks to cut holdings, just when regulators put pressure on them to buy more debt to fill out liquidity buffers required under another Basel rule.

“The overall result is therefore further downward pressure on lending capacity to the real economy, possibly not what is required at this point in the cycle,” said Simon Gleeson, a financial services lawyer at Clifford Chance.

The amount of bonds in question can be huge.

Bank of Italy statistics show that Italian banks held 411 billion euros of the government’s bonds at the end of November, up from 209 billion at the end of 2011.

The review of the rule was announced as part of Basel’s work programme, published on Friday, which will include assessing the combined impact of its new rules since the financial crisis. That is a step banks have long called for in the hope that some capital charges will be reduced to encourage more lending to the economy. (Additional reporting by Valentina Za in Milan; Editing by William Hardy and Susan Fenton)