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Cold comfort

18 April 2016 By Neil Unmack

Now is the time for banks to kick their sovereign debt drug habit. European finance ministers are considering tightening rules that make it artificially easy for banks to own government bonds. The drawbacks – greater pressure on banks and less flexibility for governments – are prices worth paying.

Banks’ sovereign debt addiction is one of the biggest weak spots in the euro zone banking union. European capital rules make it easy for banks to apply zero risk-weights to their own sovereign debt, and circumvent single exposure limits. Banks use this wheeze to make outsize bets on sovereign debt. Italian banks have 12 percent of their assets invested in their sovereign bonds.

This vogue has helped unprofitable banks and weak governments survive in difficult times, but has probably stopped them supporting private capital. The status quo makes northern states wary of agreeing to common deposit insurance, since they know that this amounts to a sovereign guarantee.

A fix carries several drawbacks. Banks would lose some of their income, and may need more capital. Governments could no longer rely on banks to fund them when other investors are wary.

The numbers are also daunting. In 2014 Fitch Ratings estimated banks would need to sell 1 trillion euros of bonds to shift from the current system to the so-called standard limit on single exposures. Assuming a 50 percent weighting, Italian banks would see their bonds’ risk-weighted assets rise by over 150 billion euros, meaning the system’s common equity tier 1 ratio could fall below 10 percent, according to Breakingviews estimates.

The usual workaround is for banks to be given a long lead-time for the new rules to kick in. But markets may push them to act sooner. That could mean banks only holding capital above exposures of a certain size.

But there are reasons to act now. With interest rates low, banks can sell at a profit, and the ECB’s pledge to buy bonds should prevent prices collapsing. Its purchases match the trillion euros of bonds that would be sold.

Best of all, tackling the sovereign addiction should also help overcome German opposition to a common backstop for a single deposit insurance scheme. That should lower funding costs for weak banks. It would also send a powerful message that the euro zone – despite all its issues – is able to integrate.

 

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