January 8, 2018/Fitch Ratings
The Basel Committee on Banking Supervision’s decision late last year not to propose changes to the favourable treatment of banks’ sovereign exposures will shift the debate on how to reduce banks’ risks from sovereign exposure back to the EU, Fitch Ratings says.
EU policymakers had identified risk reduction for sovereign exposures as a key requirement for completing the banking union. However, the sovereign-bank link will remain significant and we expect policy measures requiring banks to diversify their sovereign exposures will take time to agree and implement. EU banks’ exposures remain concentrated on their home governments despite some diversification in recent years.
The Basel Committee announced in December 2017 that it had not reached consensus on making changes to the treatment of sovereign exposures, instead publishing a discussion paper to inform its longer-term thinking rather than a consultation on specific proposals. Sovereign exposures benefit from favourable treatment in the Basel capital framework, including discretion to apply a zero risk-weight for many domestic exposures, and exemptions from the large exposures regime, which would otherwise constrain many banks’ ability to hold sovereign debt. The Basel Committee’s liquidity coverage ratio requirements also treat sovereign exposures favourably.
The discussion paper makes clear the committee’s view that sovereign exposures entail risk, but also highlights the importance of banks as investors in funding government borrowing. The paper suggests various other possible approaches to sovereign exposures, including standardised risk weights, increasing capital charges for exposures above certain levels and extra disclosure requirements.
During the eurozone crisis, large sovereign debt holdings at many banks meant that the increases in sovereign risk and valuation losses on sovereign debt led to concerns about certain banking systems’ and individual banks’ solvency. More recently, the EU debate on sovereign exposures has been prompted by moves to set up a common deposit insurance scheme with risk mutualisation as part of the envisaged banking union. This could mean taxpayers in one country having to foot the bill for protecting deposits in another. Some countries have insisted on risk reduction measures alongside risk sharing, a point reiterated in European Commission President Jean-Claude Juncker’s 2017 State of the Union address.
The European Council said in 2016 that it would await the outcome of the Basel Committee’s review of the regulatory treatment of sovereign exposures, a position reiterated by the European Commission in October 2017, when it envisaged that risk-reduction and risk-sharing measures would be in place by spring 2019. However, this looks ambitious with Basel policy development now seeming to be on a longer time-scale and EU Parliament elections taking place that year.
A European Commission proposal to create sovereign bond-backed securities to help banks to diversify their sovereign bond holdings did not include specific proposals for associated prudential requirements. Any moves to impose prudential requirements on banks’ sovereign exposures could result in portfolio shifts or discourage banks from increasing domestic government debt holdings in anticipation of the impact of forthcoming requirements. Smaller banks would typically be more affected as they tend to have more concentrated exposures.
As the ECB phases out its sovereign bond purchases and markets will have to start absorbing net issuance once again in 2019, yields may rise in core eurozone countries and peripheral sovereign spreads may widen.
Fitch will discuss European banks at its Credit Outlook Conferences in Paris, London, Madrid, Frankfurt, and Milan starting this week. Details are available at www.fitchratings.com.