European banks may soon have to account for govt debt risk

Brussels

THE days of European lenders being allowed to load up on government debt without having to account for risk are numbered, according to Daniele Nouy, the euro area's top bank supervisor.

A regulatory loophole that allows banks to apply a zero risk weight to much of their government debt holdings and avoid any capital charge should be closed, said Ms Nouy, who heads the European Central Bank's oversight arm.

"It was confirmed during the crisis that there are no risk-free assets," Ms Nouy said in a Jan 28 interview in Frankfurt. "So there should be a risk weight, capital requirements for sovereign exposures."

She said she sees movement towards closing the loophole. "It will happen," she said.

Under European Union rules, banks can rate all debt issued by the bloc's 28 national governments as risk-free. This encourages so-called carry trades, whereby lenders borrow at low cost from the ECB and plough the money into state debt that offers higher returns.

"Probably at the end of the day it will not be much - the capital requirement will be limited because on average those exposures are of good quality," Ms Nouy said. "But indeed, what is not risk-free should have a capital requirement. That's quite clear."

Euro-area government securities accounted for 9.3 per cent of total bank assets, or 2.4 trillion euros (S$3.68 trillion), in December, according to ECB data.

Given the scale of the issue, regulators are likely to take a "softly, softly" approach on zero risk weighting, said Sharon Bowles, a former chairman of the European Parliament's Economic and Monetary Affairs Committee.

"It's absolutely right that the eurozone has to do something about it," said Ms Bowles, who pushed unsuccessfully for legislators to tackle the issue in a 2013 overhaul of EU capital rules.

Not everyone in the ECB is sanguine about changing the way sovereign debt is treated. While some, such as ECB Executive Board member Yves Mersch, see the need for change, they worry about the consequences.

"Any regulatory initiatives to address this issue can only be introduced very gradually in order to avoid market turmoil, and most likely only in the context of other governance reforms," he said last year.

Ms Nouy said that within Europe, "there are certain voices that recommend caution because we're not out of the crisis, but I've not heard what I would call resistance on this, at least among supervisors".

Some stirrings can be seen at the global level, where the Basel Committee on Banking Supervision has included a review of the regulatory treatment of sovereign risk in its work programme for this year and next. No EU initiatives are on the table, however.

The source of the zero-risk rule is a matter of dispute between Basel and Brussels.

ECB president Mario Draghi has said repeatedly that the status of state debt originates with the Basel committee. Ms Nouy echoed that view, saying the treatment of government debt as risk-free is "permitted by the Basel committee".

Mr Draghi's ECB and the supervisory arm run by Ms Nouy represent the EU on the Basel committee, which brings together regulators from nations including the US, UK and China to coordinate rule-making.

Basel has rejected the ECB view.

"It is sometimes asserted that the Basel capital framework prescribes a zero-risk weight for bank exposures to sovereigns," the Bank for International Settlements, which houses the Basel group, said in December 2013. "This is incorrect."

EU regulations give banks far wider scope to use the zero risk weighting than Basel standards envisage, the committee maintains. In December, it judged the EU to be "materially non-complaint" with global accords in its implementation of the internal- ratings-based approach to assessing credit risk, which encompasses the treatment of government debt.

Under Basel rules, banks can seek permission from their supervisors to measure risk using their own internal models as an alternative to applying a Standardised Approach drawn up by regulators.

Once permission is granted, the bank is expected to assess all significant risks using its models. For "non-significant business units" and asset classes "immaterial in terms of size and perceived risk", the Standardised Approach can still be used, according to the BIS.

This second method allows national supervisors to reduce risk weights for sovereigns "provided that the exposures are denominated and funded in the currency of the corresponding state". In practice, this can mean driving them down to zero. BLOOMBERG