While Basel III, the new regulatory standard for banks has had a great deal of thought put into it, there is one element in it – a legacy from earlier formulations - that many take to be laughably out of whack. Or at least it would be laughable if the consequences were not so serious.
One of the reasons why Europe’s banks have leveraged themselves up to the hilt on the sovereign debt of peripheral European states that are now in dire danger of defaulting is that Basel III has been taken to continue the tradition of placing no requirement for banks to hold capital to offset the risks associated with AAA rated sovereign bonds.
Quite the reverse. Sovereign bonds have a prized place in bank capital structures. There is nothing stopping an Italian bank, for example, from borrowing from the ECB at 1.5% and investing the money in Italian government bonds at 7%. Many experts believe that the ECB is quite content to encourage this “free carry” because it helps Europe’s banks to repair their balance sheets slowly over time – like trickle charging a car’s battery.
However, this has two obvious downsides, first, it binds the fate of national banks ever more tightly to the fate of the sovereign, if it goes down they go down, and second, it frees banks from the necessity of engaging in more commercially useful activities such as earning revenue by supporting trade finance and working capital. This tendency is reinforced by the fact that Basel III penalises banks very heavily for engaging in precisely these commercial activities, by demanding that they hold substantially increased capital reserves to support these lending lines. Faced with this, cutting back on your lending lines is an easy solution for banks, particularly when they can make a risk free profit that imposes no capital burdens.
This was exactly the point taken up by Hervé Hannoun, the Deputy General Manager of the Bank for International Settlements (BIS). In a speech entitled: Sovereign risk in bank regulation and supervision: Where do we stand?, Hannoun makes the point that the pricing of sovereign risks in recent years has been a market phenomenon that had nothing to do with Basel III, or Basel II either for that matter. The pricing of sovereign risk was “complacent” he says, which is code for saying people simply wilfully ignored the possibility of a European sovereign default and therefore priced sovereign bonds way too low and bought way too much of them.
What needs to happen henceforth, he argues in his speech, is that “although sovereign assets are still a relatively low risk asset class, they should no longer be assigned a zero risk weight and must be subject to a regulatory capital charge differentiated according to their respective credit quality.”
It is hard to fault Hannoun’s analysis:
“… sovereign risk pricing in financial markets follows a well known pattern: we observe long periods of complacency during which risk premia and risk perceptions are unusually low while risks are building up. These periods of complacency are followed by sudden changes in market sentiment, which are both too abrupt and too late. A prolonged period of risk under prising, reflected in excessively compressed spreads, corrects in a dramatic widening of credit spreads.”
Hannoun’s point is that while market discipline works, it does so “spasmodically rather than consistently” and as such, cannot be relied upon to foster what he calls “fiscal rectitude”. He also makes the point that you need to distinguish between the risk of a sovereign defaulting, and the risk that its spread will widen significantly, together with the risk of a credit downgrade (a “credit migration event”. All these impact the market value of the bond and again, work to show that it should not be considered a zero risk asset class. In particular Hannoun is exercised by the fact that a local bank’s exposure to its own sovereign is usually disregarded when considering its exposure to sovereign bonds.
However, if we look at the Credit Default Swap (CDS) market, sovereign CDS spreads and bank CDS spreads are pretty tightly coupled, meaning that the market is not blind to the situation. The financial reporting by banks, however, remains pretty blind to both the possibility of contamination of the sovereign by bank debt and vice versa until there is actual impairment, i.e. after a sovereign default.
Hannoun ends up by arguing that actually Basel III is not to blame, since it expects banks to implement an internal ratings-based approach, which, as he puts it, does not imply a zero risk weight for highly rated sovereigns. “It calls instead for a granular approach allowing for a meaningful differentiation of sovereign risk.” What he wants is for banks to step up and grasp the full meaning of the sections in Basel III which call for them to apply “meaningful differentiation” and to start to use the readily available market pricing of sovereigns to calculate capital requirements. With Italian bonds going through the roof, banks should be responding, he says, and regulators should be waking up to the fact that Basel III does not, after all, mandate a zero risk weighting. If his view takes hold, as it probably will, given the current climate, then life is going to get very uncomfortable indeed for many a Eurozone bank. They are going to need to raise a stonking amount of capital to offset the risk to their books of holding so much sovereign debt – be that debt their own sovereign debt or a foreign sovereign debt. If this happens the credit crunch in Europe can be expected to get an awful lot worse…
Further information on Europe’s banks
- Basel III: Uncharted Territory, by Sir Howard Davies
- The Liquidity Factor, by Brandon Davies
- Banking Transparency and the Robustness of the Banking System, by Solomon Tadesse
Tags: Bank for International Settlements , Basel III , European banks , regulation , sovereign debt