Basel Rules Face Change With No-Risk Sovereign Debt a Focus

Updated on
Basel Rules Face Change With No-Risk Sovereign Debt
European banks cut their holdings of Greek, Irish, Italian, Portuguese and Spanish bonds by about 5 percent in the second quarter to about 278 billion euros, according to data compiled by Bloomberg. Photographer: Kostas Tsironis/Bloomberg

Regulators may diminish the central role of government bonds in planned banking rules designed to make the financial system safer.

The Basel Committee on Banking Supervision, which coordinates regulations for 27 countries, may let banks use equities and more corporate debt, in addition to cash and sovereign bonds, to satisfy new short-term liquidity standards, said two people with direct knowledge of the plans who requested anonymity because the talks are private. The move could reduce demand for European government securities, making it harder for nations on the brink of insolvency to fund themselves.

“One of the central pillars of the Basel III framework is the notion of a risk-free asset class,” said Matthew Czepliewicz, a banking analyst at Collins Stewart Hawkpoint Plc in London. “That central pillar is disintegrating. Basel is quite clearly going to have to be revised.”

Since rules on liquidity and capital known as Basel III were approved in 2010, holders of Greek debt have agreed to a 50 percent writedown, while prices of Italian, Spanish and Portuguese bonds have fallen as yields hit euro-era highs. Regulators now face a balancing act between acknowledging investors’ loss of confidence in sovereign debt, which has contributed to a 30 percent decline in bank shares this year, and the need to avoid undermining governments’ credibility.

Nestle, Portugal

Limiting the role of government bonds in the Basel rules is logical, said Bob Penn, financial-regulation partner at Allen & Overy LLP in London.

“In a world where Nestle is seen as less risky than Portugal, it makes complete sense, but it is politically and economically very difficult,” Penn said in a telephone interview. “The state requires someone to Hoover up its own debt. Discouraging banks from investing in some countries’ bonds could have a damaging effect on sovereign borrowing.”

Basel’s so-called liquidity coverage ratio, scheduled to be phased in starting in 2015, requires banks to hold enough “high-quality liquid assets” -- predominantly cash and government debt -- to survive 30 days of stress. Only a quarter of 28 of Europe’s largest banks would comply today, leaving a shortfall of 500 billion euros ($670 billion), according to a Nov. 29 report by Kian Abouhossein, an analyst at JPMorgan Chase & Co. in London.

‘Credit Quality’

With lenders including France’s BNP Paribas SA, Royal Bank of Scotland Group Plc and Deutsche Bank AG paring their holdings of euro-area sovereign debt, the target may be impossible to reach in its current form, analysts say. European banks cut their holdings of Greek, Irish, Italian, Portuguese and Spanish bonds by about 5 percent in the second quarter to about 278 billion euros, according to data compiled by Bloomberg.

“There aren’t enough assets in the world that are genuinely liquid and of high enough quality to allow all the banks to meet this ratio,” said Barbara Ridpath, chief executive officer of the International Centre for Financial Regulation, a London research group funded by banks and the U.K. government. “And that’s only likely to get worse because of the changing credit quality of some of the sovereigns.”

The debt crisis also is leading some regulators to question rules that allow European lenders to apply zero risk-weightings to government bonds issued in a bank’s home currency when calculating capital ratios. Under current European Union guidelines, banks don’t need to hold any capital against the securities, even after the cost of insuring government bonds against default rose to a record last month.

‘Subsidiary’ Bonds

Regulators should distinguish between the sovereign debt of countries that have control over their own monetary policy and “subsidiary” sovereign bonds issued by countries in the euro zone, Adair Turner, chairman of the U.K.’s Financial Services Authority, said in a Nov. 21 speech at the Centre for Financial Studies in Frankfurt.

“The current favoritism toward sovereign debt, inherent in prudential capital liquidity requirements and in central bank collateral rules, should in future apply only to fully sovereign debt, and either not apply at all or to a far lesser extent to subsidiary sovereign debt,” Turner said.

Some U.S. bankers, including Jamie Dimon, CEO of JPMorgan, the largest U.S. lender, have called for an overhaul of the current risk-weighting regime, which allows banks to use their own models to assess the safety of assets and how much capital they need to hold. U.S. lenders are governed by Basel I rules that assign standardized weightings to broad classes of assets, since the U.S. never adopted the second round of regulations that are in effect in the EU.

‘Large Disparities’

The proportion of risk-weighted assets to total assets at European banks is half that of U.S. banks, according to an April 6 report by Simon Samuels and Mike Harrison, analysts at Barclays Capital in London. In testimony in June before the House Financial Services Committee, Federal Reserve Governor Daniel Tarullo called on regulators to stamp out the “large disparities” in how banks apply weightings before Basel III is implemented.

Scrapping the zero-risk-weighting provision in calculating capital ratios would force banks to choose between raising hundreds of billions of euros or cutting lending, which analysts say could worsen the region’s economic crisis. Economists at UBS AG and Frankfurt-based Deutsche Bank are predicting a recession in the euro zone next year.

Liquidity Buffer

Under proposals published by the Basel committee in December 2010, at least 60 percent of a bank’s short-term liquidity buffer must be in cash or securities underwritten by governments and central banks. The remainder can include corporate bonds rated AA- and covered bonds.

The committee is reviewing the proposals and plans to announce potential changes in the first quarter of next year, according to a September statement.

Analysts and economists question whether it’s still appropriate to require lenders to hold such a large proportion of government bonds.

The 46-member Bloomberg Europe Banks and Financial Services Index has fallen about 30 percent this year and the companies are trading at a 37 percent discount to book value, according to Bloomberg data. Moody’s Investors Service said Nov. 28 it may cut the credit ratings of 87 banks in 15 countries because of the “rapid escalation of the euro-area sovereign and banking credit crisis” and the “absence of policy measures that stabilize market conditions.”

‘Toward Insolvency’

“It’s difficult to see how the rules can come in in their current form,” said Edward Chan, a banking lawyer at Linklaters LLP in London. “On the one hand, they require banks to hold euro-zone sovereign debt to meet liquidity targets, yet holding those securities pushes them further and further toward insolvency.”

When the coverage ratio was first proposed in December 2009, the spread in yields between Spanish 10-year government bonds and German sovereign debt of a similar maturity was about 60 basis points. It widened to a record of 469 basis points on Nov. 22. During that time, the spread between Italian debt relative to German securities ballooned to a record 553 basis points from about 80 basis points. A basis point is one-hundredth of a percentage point.

“The whole notion of risk-free public-sector debt is bedeviled by problems,” Charles Goodhart, a former Bank of England policy maker and a professor at the London School of Economics, said in a telephone interview. “It’s very difficult to say that all countries in the euro zone are equally risk-free when the market suggests they are not in a very strong way.”

German Bond Sale

Even governments once considered safe are struggling to attract investors. Germany failed to sell about 35 percent of the 6 billion euros of 10-year bonds it offered on Nov. 23. Standard & Poor’s is poised to place all 17 euro nations on review for possible downgrade, according to two officials familiar with the decision who declined to be named. That would leave Germany and France at risk of losing their AAA ratings.

Meanwhile, the turmoil in Europe has boosted demand for government bonds of countries outside the euro zone, pushing yields lower. Ten-year U.S. Treasuries yielded about 2.08 percent as of 6:15 a.m. in New York, compared with 3.29 percent at the start of the year. Yields on Swiss government bonds of a similar maturity tumbled to 0.82 percent from 1.64 percent, and U.K. gilt yields shrank to 2.32 percent from 3.40 percent over the same period.

“Day by day, there seem to be fewer asset classes that the market regards as risk-free, such as U.S. Treasuries and Swiss government bonds, and the banks can’t all load up on U.S. debt,” said Collins Stewart Hawkpoint’s Czepliewicz.

Equities Turnaround

Under one option being considered, banks could increase the proportion of the buffer that can be made up of high-grade corporate and covered bonds, said one person with knowledge of the review.

Regulators could also decide to allow banks to use equities to meet the liquidity requirement, two people familiar with the review said. That would mark a turnaround. Stefan Walter, who left his post as secretary general of the Basel committee in October, told Risk magazine in June that equities weren’t being considered for inclusion.

“The liquidity standards clearly outline the characteristics for high-quality liquid assets,” Walter said in the interview. “Equities fail to meet these characteristics as they typically carry considerable credit and market risk, are often correlated with risky assets and, in times of crisis, tend not to be flight-to-quality assets.”

Net Cash Outflow

Broadening the definition of the liquidity buffer to include more liquid assets such as equities would make sense, said Kinner Lakhani, a banking analyst at Citigroup Inc. in London. The securities should be subject to “significant haircuts” to reflect price volatility, he said.

“The cash sovereign bond market has been less liquid than many would have imagined,” Lakhani said. “At least equities remain a liquid asset class.”

Allowing banks to use equities would help firms with significant market-making operations because they could use the equities they already hold for the buffer, Lakhani said.

Under the plan being considered by the Basel committee, equities could be counted in calculating a lender’s coverage ratio, one of the people familiar with the talks said. While they would continue to be ineligible as high-quality liquid assets, proceeds from the sale of publicly traded shares a lender owns could be used to offset a bank’s net cash outflow, the total likely to leave a business under stress, the person said. In practice, this would allow banks to reduce their holdings of sovereign debt by increasing the equities they own.

Frozen Markets

That may bring its own difficulties, said Andrew Stimpson, an analyst at KBW Inc. in London.

“Equities aren’t going to do very well if you’re entering a scenario where outflows do happen, as you’re going to have other banks selling stocks as well,” he said in an interview. “That is going to create a spiral, which sounds like a disaster.”

Under Basel III, lenders also are subject to a second liquidity buffer, known as the net stable funding ratio, which requires them to cut their reliance on short-term money markets by boosting holdings of debt with longer maturities. Equities can be used in calculating that ratio.

While lenders have until 2018 to comply, that could prove difficult with funding markets frozen and investors demanding record interest rates to buy bank debt, analysts say.

European banks have sold about 14.6 billion euros of senior unsecured bonds since the markets constricted at the end of July, compared with 73.7 billion euros in the same period last year, according to Morgan Stanley data. The European Central Bank’s balance sheet rose to a record 2.42 trillion euros in the week through Nov. 25, about 500 billion euros more than a year ago, as banks tapped it for funds because they were unable to borrow from one another.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE