Bank Watchdog in Sweden Exposes Europe to Uncomfortable Truth

  • FSA questions on sovereign debt risk may spread across Europe
  • Sweden says risk weights should distinguish between countries

Sweden’s decision yet again to take the regulatory high ground is proving awkward for much of the rest of Europe.

A director at the Swedish Financial Supervisory Authority last week dared to question the status quo of letting banks treat sovereign bonds as though they couldn’t default. For Sweden, the move will probably only result in a modest increase in bank capital needs, but the political statement behind the decision is significant.

Greek yields expose the absurdity of bank rules allowing a zero risk weight on sovereign debt

“Everyone will be looking at the Swedish market, just to see what impact it has,” said Fabian Gerlich, a fixed-income research analyst specializing in public issuers at Nord/LB. “It could be a prototype for what would happen in the euro area, if they decided to do something similar.”

The context is important. Sweden is putting the spotlight on a regulatory absurdity after facing criticism that its own banks were taking too rosy a view on some credit risks, including their treatment of mortgage assets.

“This move is smart,” Karl Morris, a London-based analyst at Keefe Bruyette & Woods, said by phone. By forcing the conversation over to the much bigger question of sovereign risk, the Swedish FSA has managed to “turn the tables a bit” on regulators elsewhere in Europe, he said.

The Stockholm-based FSA has told Nordea, SEB, Handelsbanken and Swedbank to submit proposals to show how they will treat sovereign debt using internal ratings models. The regulator is due to respond at the beginning of 2016.

Uldis Cerps, executive director of banking at the FSA in Stockholm, says attaching a risk weight of zero should only be allowed if that reflects reality. Risk weights should clearly distinguish between government bonds, he says.

It’s hard to argue with the logic. The question now is whether others will follow.

But for some euro-zone banks, doing so “would be a massive shock,” Gerlich said. “In the euro area there’s also a tighter connection between banks and governments, especially in the periphery, where banks hold lots of sovereign bonds.”

Josef Korte, a researcher at the Goethe University, Frankfurt, and co-author of a paper “Zero Risk Contagion -- Banks’ Sovereign Exposure and Sovereign Risk Spillovers,” warns that “banks that have a lot of sovereign debt on their balance sheets could all of a sudden become unstable if risk weights on government debt were introduced.” There’s a risk their “capital ratios wouldn’t comply with minimum requirements.” He says that’s why such a requirement would have to be “introduced step by step.”

Even in the rest of Scandinavia, where governments all enjoy AAA ratings, Sweden stands out in its treatment of sovereign bonds.

Norway says it’s waiting on Basel and European regulators to lead the way. In Denmark, which a few years ago was outspoken on what it characterized as the lunacy of Basel III liquidity rules that gave Greek sovereign debt a higher status than AAA-rated Danish covered bonds, the regulator is this time taking a back seat.

“We have no plans for front-running the international development,” said Kristian Vie Madsen, deputy director at the Danish FSA.

To be sure, European regulators have been trying to address the issue for years. Ignoring default scenarios on sovereign debt became an even more difficult position to defend after the debt crisis left a number of governments relying on international bailouts.

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. How to set risk weights on lower-rated European sovereigns is still being discussed, while Basel has already consulted on how minimum buffers for other risk groups might be set. It expects to publish the final version before the end of the year.

Sweden’s banks have lower risk weights than their peers, averaging 25 percent compared with 35 percent for major European banks, according to the FSA. Much of that difference reflects smaller loss ratios at Swedish banks, though there’s some debate over whether historic impairment data are an adequate tool for predicting future losses.

Either way, should anyone question Sweden’s approach to booking mortgage risk, the country can now quickly point its finger at others’ questionable treatment of sovereign risk, according to Morris at Keefe Bruyette & Woods.

“It’s easy for the Swedish regulator to implement this, given the limited impact,” Morris said. “But it will probably be less welcome on the continent.”

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