Swedish Plan to Expose Banks' Sovereign Debt Risk Gets EBA Help

  • Nordea backs effort, citing Greece's brushes with default
  • Lack of data likely to make internal models unworkable in end

Sweden’s decision to stop its banks pretending all government bonds are safe is getting some backing, albeit short-term, from European regulators.

The London-based European Banking Authority says it will help come up with the best guides for modeling sovereign debt risks. At the same time, the EBA says Sweden’s chosen approach, internal ratings models, won’t work in the long term for lack of data.

“If you have only three, four observations, how are you going to come up with a meaningful loss model?” Lars Overby, head of unit regulation at the EBA, said in an interview in London.

Breaking with the rest of Europe, Sweden has told its biggest banks they no longer can simply assign a zero risk to their sovereign-debt holdings. From next year, banks can’t rely on standard models, which allow the weighting, and must instead calculate the probability of default and how much they stand to lose, using historical data.

The EBA says it’s helping figure out those numbers, but it’s a tough problem because the limited data leads to a range of results, something the agency has seen time and again.

“One of the difficulties that has been found in a number of EBA reports is that you see a lot of fluctuation on how to model the defaults,” Overby said.

Scandinavia’s biggest bank has done some studies that back the EBA’s point. Nordea has analyzed internal models from “banks across Europe,” Rodney Alfven, head of investor relations, said by phone. “There’s a very, very wide range to the risk weights.”

While the modeling itself is less complicated than for corporate exposures, determining default probabilities and possible losses for sovereign debt “is where you have a judgment call,” Alfven said.

That doesn’t mean Nordea doesn’t support the Swedish regulator’s efforts. “Given what’s happened in Greece, it’s good to have an IRB model,” he said. “A government bond is a government bond, but there are different risks with different sovereigns.”

The Financial Supervisory Authority in Stockholm expects to decide in early 2016 on models submitted by Nordea and Sweden’s three other largest banks. The Swedish Export Credit Corp. has also submitted a proposal. The regulator took the step after growing impatient with European standards that allow zero risk weighting.

The EBA is sympathetic to Sweden’s position, Overby said. The London-based agency is working to harmonize probabilities of default and likely losses for government debt. That work precedes a review to decide which portfolios, including sovereign debt, are suited to internal modeling.

“I would agree with the point that there is clearly a risk on sovereigns, but on the other hand, how to find the right approach to this, and the right model for modeling, this is much more difficult,” Overby said.

That’s because internal models, to be truly effective, need reams and reams of historical data. And historically, governments rarely default.

Basel has started a review on the matter and “will consider potential policy options,” Chairman Stefan Ingves, who is also Sweden’s central bank governor, said in a Nov. 2 speech.

The review could have far-reaching financial and political ramifications. One proposal would be to apply a large exposure limit to government debt. That would force banks to either raise more than 6 trillion euros ($6.4 trillion) in additional capital or dump more than 1.6 trillion euros of government bonds, according to European Central Bank estimates.

The Basel Commission on Banking Supervision said in a December report the EU was “materially non-compliant” in its adoption of global rules regarding credit risk. Decisions to let banks hold no capital against risky government debt and less capital against loans to small and medium-sized businesses constitute “major departures” from the Basel framework, the global regulator said.

In the meantime, internal risk-based models are “the only alternative if you want to have non-zero risk weights and clearly some supervisors are of the opinion that non-zero risk weights are a good thing,” Overby said. “The EBA work focuses on clarifying the definitions, but this is only one part of the answer.”

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