Banks in Sweden Told to Add Risk Weights to Government Bonds

  • Sovereign debt holdings need to reflect market reality: FSA
  • Swedish FSA says it couldn't wait for EU to complete review

Sweden has told its banks to stop pretending all government bonds are safe.

With Greece on the verge of bankruptcy numerous times over the past five years, the cat’s out of the bag: it is possible to lose money on sovereign debt. That means banks should no longer be free to operate as though that weren’t the case, according to Sweden’s Financial Supervisory Authority.

Though European regulators have been trying to address this issue, Sweden didn’t want to wait for a region-wide decision before acting, Uldis Cerps, executive director of banking at the FSA in Stockholm, said in an interview.

It makes little sense that while “sovereign risk is being priced in markets on a daily basis,” banks “would be, by the regulatory framework, allowed not to take this into account in their capital planning,” he said.

European Yields

Within Europe alone, government bonds trade at very different yields, with investors in short-term debt sold by Switzerland, Germany and Denmark paying for the privilege of lending to those governments. Meanwhile, two-year Greek notes trade at about 8 percent.

Sweden has told its four biggest banks that they can’t adopt the standardized models, which would allow them to use risk weights as low as zero on sovereign debt. Instead, they must come up with internal ratings systems and assign realistic loss probabilities to the assets. The method also needs to apply to municipal debt, Cerps said.

The regulator is now reviewing models submitted by Nordea, SEB, Handelsbanken and Swedbank, which together have assets equivalent to about four times Sweden’s gross domestic product. The Swedish Export Credit Corp. has also provided its internal ratings model for assessment.

The FSA plans to have a response ready at the beginning of next year, Cerps said. The agency will look at how debt from Greece, for example, is weighted against Germany, he said.

“That is a modeling option that we certainly have an opinion on,” Cerps said. “The underlying idea, of course, is that you have some kind of differentiation. You clearly see the differences if you look at market pricing of sovereign debt.”

Sweden already last year started using its national regulatory freedom under so-called Pillar 2 rules to require banks to hold capital against sovereign debt. The risk weight attached to an asset determines how much capital a bank must hold to protect it from losses.

“We needed to take more short-term measures to assure the banks aren’t relying on having a possibility of enjoying a zero-percent risk weight,” Cerps said. In Sweden, the extra capital allocation is likely to be modest. “It isn’t a measure that requires much capital; it is more of a kind of good housekeeping matter,” he said.

Global regulatory efforts to reflect sovereign debt risks on banks’ books are riddled with provisions that ultimately give governments preferential treatment, according to a March study by the European Systemic Risk Board. These include smaller haircuts when the debt is used as collateral or held as liquid assets.

European Commission President Jean-Claude Juncker earlier this year proposed limiting the amount of sovereign debt banks may hold. Yet such a “far-reaching” step should be part of a global assessment, he said. The Basel Committee on Banking Supervision is reviewing sovereign debt treatment as it looks at how low-default portfolios generally should be handled.

Denmark’s FSA said it won’t follow Sweden’s lead in a step that seemingly contradicts a recommendation by the country’s central bank. Denmark also argued in favor of a more critical approach to measuring asset risks back when Basel proposed giving its AAA-rated covered bonds a lower liquidity status than sovereign debt.

Sovereign risk isn’t “a major risk factor in a Danish context,” Kristian Vie Madsen, the agency’s deputy director for banks, said in an e-mailed response to questions. “Therefore, we have no plans for front-running the international development by introducing such risk weights on a national level.”

Nordea Chief Executive Officer Christian Clausen said in an interview last week he expects regulators to conclude some exposures are best handled using internal models while a standardized approach is more suitable for others, including sovereign debt.

“Why should we all model sovereign debt,” Clausen said. “Corporate risks are much more diversified and much more different, so it makes much more sense to risk model the corporate risks.”

It’s not the first time Sweden has moved aggressively to shore up its banking system well before the rest of the European Union. The FSA requires total capital of up to 25 percent of risk-weighted assets for some Swedish banks. The lenders’ sovereign debt exposure was about 5 percent of total assets in 2013, according European Banking Authority figures. That compares with as much as 17 percent for Belgian banks.

Sweden’s decision to require banks to use internal models on sovereign bonds marks something of a departure from the guidance given on other asset classes. The regulator has chided banks for relying on overly optimistic internal calculations for mortgage and corporate assets.

Cerps says standardized models are there to ensure banks don’t cut corners using their own, tailor-made calculations. But when standardized models themselves lead to a rosier world view than is desirable, then alternatives need to be found, he said.

“We have to keep in mind that the alternative of not modeling them is having a zero risk weight,” he said.

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