December 7, 2010 / 2:12 PM / 8 years ago

Analysis: EU in a bind over "risk-free" sovereign bonds

LONDON (Reuters) - Allowing banks to avoid capital requirements on the riskier sovereign debt they hold is becoming untenable as the European Union agreed to bail out a second euro zone country on Tuesday.

Ending the anomaly, however, will come at such a cost for lenders, markets and the economy that policymakers will still err on the side of caution.

Under EU rules a lender’s exposure to government bonds in its domestic currency, such as the euro used in 16 member states, has a zero risk weight for determining capital buffers in case of default.

Banks in the euro zone, therefore, have little regulatory incentive to differentiate between euro denominated sovereign debt.

This risk-free status has directly contributed to the development and severity of the market turmoil on bond markets, said Achim Kassow of Commerzbank’s board of managing directors.

“The fixed risk weight of zero percent ... has, in our view, played a direct role in the excessive build up of low-quality sovereign debt in bank portfolios as well as of high levels of debt in certain sovereigns,” Kassow added in a research paper for the European Parliament.

EU finance ministers formally agreed to a bail out for Ireland on Tuesday after doing likewise for Greece, another euro zone country, earlier this year.

Markets believe a third member of the single currency area, Portugal, is next in line for the bloc’s soup kitchen.

The impact of zero-risk weights is deep-seated.

Austrian financial consultancy MK Ceba calculates that over 60 percent or 1.25 trillion euros of international bank claims against four euro zone countries, Greece, Ireland, Spain and Portugal, are financed by banks in the single currency area.

GROWING FICTION

Pressure for change has begun after EU leaders agreed recently that holders of sovereign debt may have to accept a haircut or reduction in payouts in future crises though this would not affect debt issued before 2013.

European Central Bank Governing Council member Mario Draghi said this week some repricing of euro zone debt was inevitable.

From 2013 banks will also have to start building new liquidity buffers under global standards known as Basel III and the bulk must be in the form of government debt, thereby accentuating the impact of zero-risk weights unless changed.

“Is it right that the regulatory framework governing all types of financial institution in the EU should continue with the fiction that debts of EU-penalized governments are risk- free?” said Graham Bishop, a former investment banker and now a consultant on EU financial services.

Regulatory changes made due to the financial crisis will go some way to blunting the impact of the zero-risk weight rule.

Global bank capital rules from the end of 2011 will force lenders to set aside more capital if there are any ratings downgrades on assets held on their trading books.

A requirement from 2013 under Basel III for banks to build up extra “countercyclical” capital buffers when credit markets get frothy will generate liquidity that can be tapped if bond markets crater.

Banks will also face regular stress tests by supervisors which should spot concentrations of risky sovereign debt and call for action such as extra capital or liquidity.

The leverage ratio also being introduced under Basel III to cap how much banks can extend themselves will include government bond holdings for calculation purposes.

“There is a floor underneath how low a risk weighting can go,” an expert in Basel III said.

NO EASY ALTERNATIVES

Changing the actual risk-free rule itself will be harder.

The European Parliament is set to vote through a resolution next week but so far there is no consensus on changing the rule as some countries like Germany are uneasy.

A cap of some sort on exposures may be looming.

“The main issue is to avoid concentration in certain asset classes like sovereign debt,” said Othmar Karas, an Austrian center-right member of the assembly.

Parliament has joint say with EU governments on introducing Basel III into EU law next year which offers a vehicle for addressing zero-risk weight.

“We have got a big hole that we have to address,” Sharon Bowles, the British Liberal chairwoman of parliament’s economic affairs committee, told Reuters.

Remedies come at a cost, however,

Better quality ratings from the credit rating agencies would help flag risks in government bonds, experts say, but this contradicts a push among regulators to dilute the influence of ratings on financial markets.

Forcing euro zone banks to set aside capital to cover less- rated debt would impact interest rates and financing volumes for the broader economy, MK Ceba said.

Most banks could not comply with a cap on exposures to sovereign debt unless the debt remains zero-risk weighted, it added.

MK Ceba estimates that assuming 30 percent of the exposures to euro area government debt were affected by introducing a 20 percent risk weight, lenders would need 12 billion euros in extra funds.

This may not be much in the overall banking sector picture but it would come on top of the extra funds banks will have to find to comply with Basel III.

Scrapping the zero-risk weighting would also undermine the EU’s political objective of real and nominal economic convergence and create a two-tier sovereign debt market.

“For sovereign risk, it quickly becomes apparent that the range of sensible alternatives is limited,” Commerzbank’s Kassow said.

Editing by Stephen Nisbet

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