Sovereign-Debt Conundrum Sets Up EU for Banking-Union Stalemate

  • Task force reports unlikely to resolve deposit-insurance fight
  • Working documents show difficulty in finding practical answer

Europe’s drive to deepen integration of the euro-area banking system has bogged down as policy makers debate ways to rein in banks’ holdings of government debt.

This sovereign-debt issue has gained in importance in recent months because of Germany’s insistence that the 19-nation currency bloc should reduce the risks banks are facing, including sovereign debt on their balance sheets, before creating a common deposit insurance system to round out the so-called banking union.

The two main options on the table for dealing with sovereign bonds would be to impose limits on the concentration of debt that banks can hold, or to limit the current practice of treating many sovereign bonds as risk-free for regulatory reporting. Germany favors adding risk weights to give incentives for weaker sovereigns to sell less debt to their banks, while countries like Italy and France favor concentration limits that would prevent giving overt advantages to banks in stronger countries at the expense of their peers.

Two European Union task forces have been studying the question for months, but their reports, due by mid-year, will set out the pros and cons of possible reforms rather than deliver clear-cut policy recommendations, according to two officials with knowledge of the matter, who asked not to be identified because the talks are private. As a result, the EU may not be able to move forward with its deposit-insurance plan any time soon, complicating efforts to break the bank-sovereign loop that fueled the debt crisis.

Repurchase Agreements

Total general government securities account for 5.9 percent of total bank assets in the euro area, according to European Central Bank data. This mountain of bonds is coming under increased scrutiny from regulators because they’re often treated as risk-free for regulatory reporting, holding down capital requirements. Yet the sheer volume of state debt on banks’ books, and its role in many fundamental transactions such as repurchase agreements, will complicate efforts at reform.

EU finance ministers may discuss the issue when they convene in Amsterdam next week. Some of the bloc’s 28 nations are eager to push forward, while others prefer to wait for progress at the global level, one of the people said.

Financial Framework

The euro area’s banking union project began in 2012, when EU leaders sought to overhaul their currency zone’s financial framework to combat the crisis that led five nations to seek bailouts during the crisis. The plans called for a three-pronged approach of common supervision, common bank resolution and common deposit insurance. Four years later, only the first two are up and running.

The Netherlands, which holds the 28-nation bloc’s rotating presidency, is working on a road map that may confirm the slow timetable, and continue to leave the euro area without a full-fledged backstop that would quell a market panic.

“When a crisis approaches, banks in areas where there is no credible fiscal backstop try to buy essentially as much domestic sovereign debt as possible, in order for the country to have incentives to bail them out, before problems hit,” said Diego Valiante, head of the financial-markets unit at the Brussels think tank CEPS.

‘Credible Backstop’

As a result, euro-area nations may find that “markets are punishing them because of the lack of a credible backstop,” he said. “They are punishing the governments because they know that ultimately, if the banks go bust, their treasuries don’t have the credit line with the central bank that the U.K. has, that the U.S. has.”

The ECB, now the supervisor for euro-area banks, has called for work to speed up on common deposit insurance, and it has also waded into the fray about what to do about bank holdings of sovereign debt. 

“I am happy that this issue is now being addressed,” Daniele Nouy who leads the ECB’s supervisory arm, said on March 23. “It is addressed at an international level within the Basel Committee, and it is also addressed at the European level. Progress is good.”

Nouy said a “hybrid approach” is being discussed, whereby “the risk-weighted assets could be dependent on the concentration and on the quality of the sovereigns.”

‘Soft Limits’

Such efforts notwithstanding, EU bank supervisors have cautioned that any changes could upset financial stability unless they are very carefully planned and slowly phased in, perhaps with “soft limits” that could be adjusted in times of stress. An internal working paper from the European Systemic Risk Board, which includes the ECB, the Bank of England and other EU regulators and central bankers, says that any changes should avoid destabilizing markets or overly penalizing some nations.

“Regulations aimed at deterring risky sovereign holdings must not conflict with banks’ increasingly tight liquidity requirements, which are typically satisfied by holding sovereign debt,” according to the the ESRB draft paper, dated Sept. 18 and obtained by Bloomberg News. Also, “new prudential regulation of sovereign exposures is politically viable only if it avoids a very asymmetric distribution of costs across banks or sovereign issuers in different countries.”

The ESRB paper, prepared by the group’s advisory scientific committee, examines several options on the table, such as a 25 percent limit on the sovereign bonds some banks can hold risk-free as a share of eligible capital.

Excess Supply

According to ESRB simulation results, applying a 25 percent large-exposure limit on the sovereign debt of each single issuer implies that the largest excess supply would arise for Germany’s bonds, at 270 billion euros, followed by 200 billion euros of Italian sovereign debt, and 115 billion euros for both Italy and Spain. If the large-exposure limit were raised to 50 percent, the excess supply for German, Italian and Spanish debt would become 150 billion euros, 135 billion euros and 78 billion euros respectively.

Other models show “critically different” results depending on how the large exposures are calculated, in some cases actually increasing demand for bonds from some nations. One alternative would exempt a portfolio of bonds that is weighted according to gross domestic product across the region, while another model involves a synthetic product called European Safe Bonds, or ESBies, as proposed by Princeton economist Markus Brunnermeier in 2011.

The ESRB confirmed the authenticity of the paper, but said it’s a draft and that a final version will be published later in the year.

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