Banks Face Basel Review of State-Debt Capital Loophole

Banks’ ability to escape higher capital requirements when they buy sovereign debt is facing scrutiny from global regulators amid concerns that it undermines attempts to sever links between governments and lenders.

The Basel Committee on Banking Supervision, a group bringing together regulators from 27 nations, is beginning to study the loophole, which in the European Union has allowed banks to treat any debt issued by the bloc’s governments as risk-free and exempt from usual rules on how banks should fund a portion of their investments through equity rather than debt.

“The issue is very much a real one,” Niall Bohan, a European Commission official for bank and financial conglomerate rules, said today at a conference in Brussels. “I know Basel is starting to think how it might take work forward in this respect,” he said. “We have to engage with that issue. It is an issue that concerns people.”

Nearly two years after European Union leaders pledged to change this behavior, banks hold more sovereign paper than ever. ECB President Mario Draghi said in December that when the Frankfurt-based central bank offered about 500 billion euros ($696 billion) of new low-cost liquidity during the crisis, lenders used it “mostly to buy government bonds,” rather than for lending to stimulate the economy.

Cautious Approach

Reflections on how to address the zero risk-weighting for sovereigns will continue for some time, according to participants at the conference organized by Standard & Poor’s.

It is “widely understood” that the “sovereign-bank nexus” needs to be tackled, Bohan said. Still, regulators will “need to proceed with caution” given the potential impact on sovereign financing.

“We still have an unfinished regulatory agenda which also might include in the medium term dealing with the capital adequacy for sovereign risk,” Uldis Cerps, a member of the Basel committee, said at the event.

That is “something that the Basel committee will have to look at,” Cerps said. “At the moment, of course, one can hypothetically argue that the banks, as long as they are not holding capital for the sovereign exposures, are also getting a kind of implicit subsidy.”

For Draghi, the status of state debt originates with the Basel group’s rules.

Government bonds “in the Basel committee regulation framework are risk-less,” Draghi said in January.

Basel Standards

The Basel committee rejects this view.

“It’s not the Basel rules that say you can provide zero percent risk weighting,” said Bill Coen, deputy secretary general of the Basel committee. “It’s not part of our rules.”

According to the Bank for International Settlements, which houses the Basel group, the loophole arises from the way global rules have been implemented by nations.

Under Basel standards, large banks are required to measure all significant risks using their own models. For “non-significant business units” and asset classes that are “immaterial in terms of size and perceived risk,” an alternative set of rules, the Standardized Approach, can be used, the BIS said last year.

This second method allows national supervisors to reduce risk weights for sovereigns “provided that the exposures are denominated and funded in the currency of the corresponding state,” according to the BIS. In practice, this can mean driving them down to zero.

In Europe, banks are allowed to use the Standardized Approach permanently for sovereign holdings and to apply a zero risk weight to debt issued by any EU government in any of the bloc’s currencies.

The zero risk weighting also applies in some cases in the U.S., which is still in the process of rolling out capital rules that allow use of internal models.

The Standardized Approach allows a zero risk weighting in the case of a “very highly rated sovereign,” Coen said.

Still, “most of the big banks, all the global systemically important banks, ought to be using the internal ratings-based approach,” he said.

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