Ending ‘Doom Loop’ Could Cost European Banks Billions in Capital

  • $195 billion capital needed in punitive scenario, Fitch says
  • Issue is significant stumbling block for banking union

Changes to the capital treatment of sovereign bonds discussed in Brussels and Basel may force European banks to raise as much as 171 billion euros ($195 billion) in new capital or sell 492 billion euros of the securities, according to research published on Wednesday.

European banks own about 2.3 trillion euros of sovereign debt, of which about 1.5 trillion euros, or 65 percent, was issued by their home country, according to a report from Fitch Ratings. These are mostly treated as risk-free and don’t attract capital charges, an assessment that was called into question when the euro debt crisis exposed possible contagion between countries and their banks, sometimes dubbed the “doom loop.”

Assigning a capital charge to sovereign bonds has been discussed by the European Commission, the bloc’s executive arm, and by finance ministers, and is being studied by the Basel Committee on Banking Supervision. The issue has gained importance after Germany insisted on it as a condition for a Europe-wide deposit guarantee system.

“The implied rebalancing could have a material impact on sovereign financing costs and could reduce sovereign financing flexibility, particularly for lower-rated EU sovereigns,” Fitch analysts including Alan Adkins, wrote in the report. “Fitch Ratings believes policy makers would act cautiously, with careful consideration of the impact and with an appropriate transitional period.”

Irish, Italian and Spanish banks have the highest exposure to bonds of their home sovereigns in the sample of banks analyzed by Fitch, though they have started to diversify to reduce concentration, the ratings company said.

Fitch looked at five scenarios based on options EU officials have considered publicly, ranging from imposing a low risk weight based on banks’ internal models, to imposing a 10 percent minimum risk weight, to a hybrid version that seeks to limit concentration and applies a rising set of charges to sovereign securities where they total more than 100 percent of a bank’s capital.

That scenario would force euro area banks to find another 135 billion euros of capital, while EU lenders outside of the single currency would need to raise 36 billion euros, according to the report. Alternatively, they could switch bonds of their home country into other securities in a revamp of almost half a trillion euros of securities.

The EU’s biggest banks would be the least affected by potential changes because they already use internal model-based approaches to calculate sovereign capital charges. They also have more diversified holdings of sovereign bonds, according to Fitch.

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