Draghi-Backed Report Says Sovereign Debt No More a Risk-Free Bet

European Central Bank President Mario Draghi

Mario Draghi, president of the European Central Bank (ECB).

Martin Leissl/Bloomberg

Government debt can no longer be considered a risk-free asset for banks, and international regulators should consider changing the existing legislation, the European Systemic Risk Board said.

“If sovereign exposures are in fact subject to default risk, consistency with a risk-focused approach to prudential regulation and supervision requires that this default risk is taken into account,” the ESRB said in a report on Tuesday, citing the majority view among its panel of experts. “Current prudential regulation of sovereign exposures is inconsistent with the conceptual approach that underlies the existing system of regulation.”

Mario Draghi, who heads both the ESRB and the European Central Bank, is pushing for a regulatory review prompted by five years of turmoil in government debt markets that almost splintered the euro area. Lenders in the European Union can use an interpretation of the Basel III international rules on banking to avoid backing their government-bond holdings with capital, an exemption the Basel rule-makers have criticized.

The ESRB started operations in 2011 with the task of monitoring the euro area’s macro-economy and the possible buildup of imbalances that could endanger financial stability. It is hosted by the ECB in Frankfurt.

‘Starting Point’

Its report was prepared by officials from the ECB and euro-area central banks, which are themselves buying government debt after starting a 1.1 trillion-euro ($1.2 trillion) quantitative-easing program on March 9, as well as European Commission personnel and academics. In a foreword, Draghi said the document should foster a discussion that is “long overdue.”

Still, after three years’ work, the ESRB panel decided not to make concrete proposals, saying the report “should serve as a starting point for policy discussions in relevant legislative bodies.” It said it expects legal changes “only in the medium term” when “the sovereign debt crisis has been resolved.”

A minority of the panel argued that sovereign-debt risk can never be adequately captured in rules directed at the banking system, and governments should instead strengthen their fiscal governance.

In December, the Basel Committee on Banking Supervision, which sets rules for the global financial system, said that the EU’s implementation of Basel III fell short of what was intended.

Crowding Out

EU rules give banks too much scope to abandon the use of internal models to measure the risks on some investments and instead to apply a so-called standardized approach, the committee said. This has in turn allowed banks to apply a zero-risk weight to a broader range of government debt.

The ESRB said the result is over-investment by financial firms in government debt, which crowds out lending to the real economy and impairs the functioning of the banking system as a whole. Even so, the high-impact, low-probability nature of sovereign default makes the area particularly difficult to regulate.

For banks, legislation could be changed to remove the special rules in the standardized approach around their exposure to the domestic sovereign, and introduce a non-zero risk-weight floor, the ESRB said. For banks that use an internal-rating approach to risk management, a floor could be set for sovereign exposures.

While the report’s authors said that the impact of changing capital regulations would likely be limited, a bigger shift would occur if regulators enforced limits on the amounts of debt from any one issuer that banks could hold.

Regulators could also re-consider recent rules on the amount of liquid assets that banks must hold to survive a market freeze, in the light of the fact that sovereign bonds should no longer be seen as riskless, according to the report.

“To the extent that sovereign exposures are themselves subject to subject to a risk of becoming illiquid, not acknowledging this risk in the regulation is problematic,” the ESRB said. The European Banking Authority said this month that the EU’s lenders need to add another 20 billion euros in easy-to-sell assets by October, to meet a Basel rule known as the Liquidity Coverage Ratio.

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