A Look At The Links Between European Banks And Sovereign Debt

European policymakers are reconsidering the favorable treatment of sovereign exposures in EU banking regulation, as part of measures to develop the EU’s banking union.

Since the sovereign debt crisis, few still believe that EU sovereigns are rock-solid and that a government default simply “doesn’t happen.” A recent reminder that sovereign defaults do happen was Greece’s recent restructuring of its commercial debt in 2012, which threatened the sovereign debt held by Greek and other EU banks, raising risks for the entire system. The introduction of effective resolution regimes in the EU in January 2016 aims to weaken the ties between sovereigns and banks, reducing the risk of government bailouts of financial institutions. But the dependency of banks on sovereign debt has proven harder to address.

EU banks continue to carry significant exposure to their domestic sovereigns. Indeed, S&P Global Ratings finds that this exposure has only grown in the past few years. One reason, we believe, is that EU banks are neither currently required to hold capital against their sovereign exposures nor face limits on the size of those investments, unlike rules that apply to other types of exposures. At the latest meeting of the EU’s Economic and Financial Affairs Council (Ecofin) on April 22, 2016, finance ministers looked at changing the rules of the game to break the “doom loop” between banks and sovereigns by proposing to:

• Change preferential zero risk weights or absence of single-obligor limits enjoyed by EU sovereign debt (in Pillar 1 of the Basel accord),
• Use Pillar 2 to assess capital and related sovereigns risks for individual banks, and
• Request stricter Pillar 3 disclosure requirements to make European sovereign exposures more transparent.

They are nevertheless taking a gradual approach to changing the status quo. Banks hold a large share of sovereign securities for a number of reasons besides their preferential regulatory treatment, including their favorable credit and liquidity characteristics, use as a collateral instrument, and to meet Basel’s newly introduced liquidity rule (the liquidity coverage ratio or LCR). Indeed, what other options for funding do certain sovereigns in Europe have, and what would banks do with their large sovereign exposures if they had to unload them?
Our view is that sovereign debt, like any other debt, is not risk-free, and for that reason our sovereign ratings fall in a wide range (for a list of current ratings see “Sovereign Ratings History,” published on May 12, 2016). Accordingly, S&P Global Ratings does not use zero risk weights in its analysis to measure bank capital introduced in 2009. Here, we address frequently asked questions about banks’ sovereign exposures and assess the impact of potential changes in banking rules for sovereign holdings in the EU.

Why do banks in Europe hold so much sovereign risk?
European banks have been implicitly encouraged to increase their sovereign bond holdings through regulatory and monetary policy, even though the purpose of banks is not to finance their national governments. Sovereign bonds are attractive for banks not only because they do not currently hold capital against their sovereign exposure in the calculation of their regulatory capital (except those using internal model-based approaches), but also because they meet Basel III’s liquidity requirements. In addition, banks heavily use government bonds for repurchase transactions in the interbank market (because of smaller haircuts than on private-sector debt securities) and for refinancing operations with the European Central Bank (ECB). What’s more, there’s an element of opportunism at work. Witness the appetite of EU banks for carry trades that they’re financing with funds from the ECB’s long-term refinancing operation (LTRO). Lastly, banks in certain countries like Spain and in Central and Eastern Europe (CEE) use government securities to protect their interest margins from declining rates.

How big is the sovereign exposure of European banks?
Banks have generally boosted their domestic sovereign holdings over the past 10 years. Banks’ home sovereign and subsovereign securities outstanding as a percentage of total assets in the EU increased to 6.4% in February 2016 from 4.7% in February 2006–though the share varies widely from country to country (see chart 1). We note that the trend was more pronounced in Western and Southern Europe and the CEE, and less marked for banks in northern countries. What’s more, sovereign exposures can be even higher than suggested in chart 1 because EU banks hold other sovereign bonds, notably highly rated papers, issued by countries such as Germany and the Netherlands.

Plus, we found that in almost all EU countries, the exposure is overwhelmingly on the sovereign where the bank is based. The home-country bias in volume has generally increased over time, and it has since 2015 stabilized in all EU regions except CEE (see chart 2).

Why are banks increasing their sovereign exposure?
We see several explanations for increased large holdings of sovereign debt that lie in EU monetary policy, expanding
public sectors, and liquidity rules:

• The ECB has supported the increase by providing banks with cheap funding when it introduced LTROs in late 2011 and early 2012. Banks borrowed at cheap rates through the LTRO and turned around and used that money to buy government bonds with higher coupons, resulting in easy profits. In the countries where banks’ sovereign exposures increased, expanding public-sector borrowing also supported purchases of sovereign debt. Furthermore, nondomestic investors became more risk-adverse and sold sovereign debt to domestic investors that were comfortable with a home bias.
• Liquidity rules for banks favor the holding of sovereign debt, and required them to comply the LCR starting in October 2015. Basel III’s liquidity coverage ratio requires banks to hold a reserve of high-quality liquid assets as a liquidity buffer, and allows them to invest in sovereign debt without limit and not typically subject to a haircut to their market value.
• Sovereign bonds continue to be heavily used by banks for collateral posting in the interbank market for secured funding, as they typically have lower haircuts.
• Outside of the eurozone, CEE banks prefer to invest in home sovereigns and subsovereigns to avoid foreign exchange risk or the cost of hedges.

Do more demanding rules make sense when it comes to sovereign exposures?
Yes, in our view the calls for a rethink are understandable and in line with our methodology on risk-adjusted capital. Although exposures to most sovereigns are relatively low risk, they are not risk-free.

Right now, many banks use the standard formula under the Basel rules for calculating the capital they are required to hold against sovereign exposures, which calls for a zero percent risk weight. This means, in effect, that a bank does not need to hold capital against these exposures. However, this does not necessarily mean that the bank isn’t taking risk into account. Some large groups use internal models to calculate capital, which may factor in risk capital for sovereign defaults. Furthermore, regulators can impose capital increases, under Basel’s Pillar II, for risks not captured in the standard formula that so far has not dealt with sovereign exposures.

There is more risk in holding sovereign bonds than just a default. When a bank evaluates its sovereign bond exposures at market value, changes such as unrealized losses or gains can directly affect the capital position, depending on their accounting classification. A reduction in the value of the bonds, in case of steep increases in yields, can lead to a hit to the balance sheet. Falls in asset prices also reduce the value of collateral that banks use as collateral to obtain funds, adding to procyclical effects on funding.

We reflect these risks in our risk-adjusted capital framework (RACF), applying different, but always nonzero risk weights, which vary depending on the issuer credit rating on the sovereign in question. Back-testing data supports, in our opinion, this nonzero approach to risk weights that takes into account sovereign credit quality.

Which regulatory options is the EU considering to limit banks’ exposures to sovereigns?
To date, sovereign debt that EU countries issue in local currency generally benefits from a zero percent risk weight, and is excluded from any large exposures regime in Europe. With the European Council taking steps toward finalizing a banking union for the EU, the subject of sovereign exposures resurfaced at the April 22, 2016, meeting of the Economic and Financial Affairs Council (Ecofin). We understand from the published Dutch Presidency Note that European policymakers have discussed different policy options:

• Imposing caps on banks’ debt holdings vis-à-vis single countries and/or ending the zero risk-weighting of sovereign exposures in Pillar 1, or hybrid approaches where risk weights could depend on concentration and sovereign credit quality;
• Enhancements in Pillar 2 requirements via stress testing sovereign exposures and additional bank-specific requirements as part of the Supervisory Review and Evaluation Process; and
• Stricter disclosure requirements in Pillar 3 (disclosure) to reveal risks to stakeholders arising from holdings of sovereign debt.

Ecofin decided to postpone a decision on any new rules until the Basel Committee discusses this issue, to create a level playing field for banks globally and to avoid fragmentation of the bond markets. The Basel Committee is currently engaged in a review process on the topic, and plans to publish a proposal toward the end of 2016.

We believe that meaningful reform is currently out of the question because disagreements among EU members are too strong. Regulators are currently prioritizing other regulatory matters for banks, such as pushing up capital and liquidity requirements, and introducing a resolution framework to put an end to the “too big to fail” phenomenon.

If Ecofin’s options took effect, what would be the impact on banks?
We believe the introduction of risk weights greater than zero under Pillar 1 would be less disruptive than a cap. It would take a long time for banks to shrink their exposures to home sovereigns.

We estimate that limiting a bank’s general government exposures to 25% of their own funds could mean that the largest 50 banks in Europe would have to rebalance up to €1.7 trillion of EU exposures, mostly away from their home sovereign. (Note that this 25% limit is currently applied to a bank’s exposure to a single client or group of connected counterparties, and in calculating the rebalancing amount we aggregated all domestic government exposure.) Because this sum is so large, a long transitional period may be in order. This timeline may not match targets to complete the banking union by 2024.

Nonzero risk weights for sovereign exposures would require banks to add more capital, depending on the size of the risk weights. S&P Global Ratings applies such risk weights in its RACF to measure the adequacy of bank’s capital (see table 1). A risk-weight regime would maintain banks’ investment flexibility, in particular when it comes to meeting liquidity ratios such as the LCR.

More disclosure requirements regarding sovereign bond and loan exposures that are currently outstanding could lead to greater market-based discipline. With such information, investors may be dissuaded from investing in banks in distressed economies and may even withdraw funds. In turn, those banks would have fewer incentives to increase home sovereign exposures.

How does the insurance sector treat sovereign exposures?
In our insurance capital model, we apply credit default risk factors for all sovereign bonds except those we rate ‘AAA’.
For all other sovereign debt, we apply the same default factors that we apply to corporate obligations.

The European insurance industry has been operating under a new regulatory framework, Solvency II, since Jan. 1, 2016. Under Solvency II, insurers’ regulatory capital is assessed based on an economic capital framework. Each insurer can calculate its required capital based on either the standard formula (SF) or its internal model (IM). While the SF is the default option, an insurer can apply to regulators for approval to use its IM to calculate its solvency capital. An IM needs to meet demanding requirements to get approved for that purpose.

The SF doesn’t reflect EU sovereign credit risk. In contrast, most IM include sovereign risk. The European Insurance and Occupational Pensions Authority (EIOPA), which has a role in ensuring consistency in the application of internal approval processes across the EU, has commented on the requirement that risks related to sovereign exposures should be appropriately taken into account. However, we have observed that this has not happened consistently across all member states.

Also, the approach and calibration used by different insurers in their internal models could vary considerably. There are indications that EU sovereign risk may be included in the SF when its calibration is reviewed in 2018 in recognition that EU sovereign bonds are not risk-free.

What would happen if regulation indirectly pushed banks to reduce sovereign exposures?
We believe banks would diversify away from investing in their home sovereigns, reducing demand for sovereign debt in general, with wide implications for the government bond market in the EU.

We believe that such diversification would be positive. It would avoid a fragmentation of financial markets along national lines, and help protect banks from direct links to their sovereigns in times of stress by reducing concentration.

However, banks would not be immune from a default of their home sovereign, because that would likely put the domestic private sector under a significant economic stress as well. Greater diversification could also protect the capital base from the volatility resulting from unrealized losses or gains from available-for-sale portfolios.

All in all, for the European banking system, rebalancing away from home sovereigns into other sovereigns could net out, and fewer carry trades could lower sovereign exposure. With banks investing in relatively less creditworthy sovereigns, portfolio credit quality may also deteriorate. Banks in southern Europe may invest in higher credit quality sovereigns, particularly those viewed as a safe haven in stress periods, but their profitability would suffer. That’s because they would be investing in lower-yielding and even negative-yielding assets, considering that roughly 40% of government bonds trade with negative rates in Europe. This could further depress banks’ already weak profitability prospects. When it comes to meeting the LCR, the most likely nonsovereign alternative exposures would be covered bonds, with approximately €1.8 trillion outstanding in eurozone countries.

In case of a rebalancing, yields could rise on sovereigns with a weaker credit standing. The mark-to-market value of sovereign portfolios could decline, causing losses and capital adequacy challenges for banks. In turn, government funding costs in vulnerable European economies would likely increase. Liquidity in sovereign debt markets would decrease. The impact would be partly offset in the eurozone, with the ECB’s commitment to purchase sovereign bonds as part of its asset purchase programs. If the ECB did so, sovereign risks would shift away from European banks, possibly ending up on the Eurosystem’s balance sheet.

What is S&P Global Ratings’ view of discussions to reduce European banks’ holdings of sovereign debt?
EU authorities will need to tread lightly to avoid market tensions, given the currently high level of sovereign debt holdings in certain banking systems and existing pressures on bank profitability from ultralow yields and the region’s still moderate economic recovery. Profits are the main way banks build capital, which they use to meet requirements for risk-weighted assets and more demanding regulatory actions. A healthy capital buffer also limits the risk of bank deleveraging, which would have repercussions for the real economy.

Overall, we believe that rethinking the regulatory treatment of sovereign exposures is reasonable–in the long run, and achievable once disagreements among EU members are settled. More demanding rules such as nonzero risk weights or stricter disclosure requirements can bolster the resilience of the financial system in Europe, and may also benefit private-sector credit by reducing the gap in risk weights with sovereign credit.

But right now, we do not expect the EU to push ahead of a global Basel-inspired change. This would result in an uneven playing field for EU banks, and could further stymie efforts to resurrect economic growth in the region.

Nicolas Malaterre – Primary Credit Analyst – Standard & Poor’s Financial Services
Cihan Duran – Primary Credit Analyst – Standard & Poor’s Financial Services