The unsustainable lightness of zero-weighted sovereign debt
Forcing banks to account properly for the risks of their government bond holdings is one of those ideas, unassailable in theory, which tends towards the nightmarish in practice.
That sovereign bonds carry a zero-risk weighting, meaning that banks owning them need reserve no capital against the possibility of loss, is a useful nonsense. It invites over-borrowing by poorly disciplined countries and over-lending by their banks, who through leverage and the fiction of “zero” risk can profit while keeping capital too thin.
Efforts to address this in the eurozone, where the bank-sovereign link is particularly vexed and strong due to institutional weakness, appear to be moving forward, with discussions at both the European and global levels. But don’t get your hopes up.
Asked about the issue Thursday at the press conference following the European Central Bank decision to keep interest rates on hold, ECB Vice President Vitor Constancio gave a response raising more questions than answers.
“Our position … has been that first, there is reason to change the present system of zero risk-weights; second, that the revision should not create undue turbulence in markets where sovereign debt is used, such as the repo market and short-term debt markets; thirdly, that it should be a change in the international standard – that any revision of the sovereign debt risk-weight regime should be decided in an international context to ensure a level playing field,” Constancio said.
While all agree with the first point, avoiding “undue turbulence” in markets when you make the asset, sovereign debt, much less attractive to its biggest private market consumer, is a tall order. There will quite naturally be a re-pricing, and that re-pricing, turbulent or not, will be painful to both issuers and holders of sovereign debts.
“It is interesting that Constancio should have fielded this question, in so far as Italian banks are clearly most heavily exposed and the Italian government is vehemently opposed to any limits on banks’ sovereign debt holdings,” Marc Ostwald, strategist at ADM Investor Services wrote in a note to clients.
“It is at least a timely reminder that banking sector concerns, above all in the euro zone, are anything but banned by the recent bank sector equity rally, and will remain very real going forward.”
An infinite jump
Italian banks, a group which includes several troubled institutions, have about 10% of their assets in Italian government debt, making the difficulty of reform two-fold.
Should risk weights rise, more capital will be needed. While this will put the banking system on firmer footing, Italy is already struggling with recapitalizing its banks. Italian banks have clubbed together to raise a €5bn to €6bn fund to support banks, a pea-shooter rather than a bazooka given that the Italian banking system carries an estimated €360bn in troubled loans.
That figure would surely be even more swamped if Italian banks were forced to reserve against their 10% holdings in government debt.
At the same time, the process would be unpleasant for sovereigns, for whom banks serve as a semi-captive market for their debt issues.
Italy, which has both a banking and a debt habit, has expressed reservations, as you might expect.
European Union officials are weighing a number of options to address the issue, including risk weights, limits on concentration and some combination of the two. The whole issue will ultimately need to be resolved in concert with the Basel Committee on Banking Supervision.
In other words, we’ll be living with the current arrangements for quite some time.
At the end of whatever process brings a new policy we will doubtless have a gradual bedding-in process, the better to avoid “undue” volatility in financial markets. That goal will be tough to meet – after all the jump from a risk weighting of zero to a weighting of anything else is an infinite one.
The race then is between change and the next crisis in Europe. It was the last one, if you think that one is actually over, which illustrated the so-called “doom loop” between struggling sovereign issuers and their struggling banks.
Place your bets.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)