There are several questions still to be addressed in the full implementation of the agreed Banking Union actions. These include the full transposition of the Bank Recovery and Resolution Directive and of the Deposit Guarantee Directive into national law by all Member States, and making the Single Resolution Fund fully operational. Another important issue in this context concerns the exposure of banks, notably in the euro area, to debt issued by their own governments, in some cases by more than the total capital of banks. This situation remains a source of potential vulnerability that so far has not been addressed by the many reforms of the euro area or the banking legislation. This note explores possible ways to deal with this situation.
Sovereign-bank links were at the heart of the euro area crisis and remain a severe weakness as bank balance sheets are still overwhelmingly exposed to their own sovereigns. This source of risk has not been sufficiently addressed to date.
Zero-risk weighting of sovereign debt in the EU, as well as the exemption from existing large exposure requirements, are a source of vulnerability. This does not reflect a global regulatory constraint – as the global Basel framework does not prescribe zero-risk weight for bank exposures to sovereigns – but a regulatory choice made at European and global level.
Reducing this exposure could be achieved through diversification of government debt portfolios, including by the purchase of government debt of other euro area Member States.
An adequate way to operationalise risk reduction would be to introduce limits on large exposures, as they are already in place for other asset classes. The EU could introduce them itself first and work towards adoption of similar rules in the international context (a ‘Basel 3.5’ system).
There are several questions still to be addressed concerning the implementation of the Banking Union. First of all, the relevant legislation concerning the Bank Recovery and Resolution Directive and the Deposit Guarantee Directive needs to be implemented and applied in all Member States, and the Single Resolution Board needs to become fully operational. Bridge financing for the Single Resolution Fund needs to be put in place and agreement reached on a common backstop. Secondly, in addition to making sure that the agreed legislation is applied as foreseen, it may be useful to reconsider some aspects of the so-called Single Rulebook (a term used to describe the 2009 unified regulatory framework for the EU financial sector).1 Thirdly, a significant amount of national discretion also remains on macro-prudential tools, where examining these tools in more detail could be warranted. Finally, another very important point as concerning the Banking Union is the level of banks’ exposure to sovereign debt.
The possibility of funding problems in government debt markets, especially in advanced economies such as the euro area Member States, has largely been underestimated.2 The euro area sovereign debt crisis – in which government funding costs sharply diverged, resulting in a very significant increase in the riskiness of the balance sheet of banks exposed to euro area ‘periphery’ - changed this prevailing perception in two ways:
The second aspect above is sometimes referred to as the ‘doom loop’ between governments and their respective banking sector. The Banking Union, through common supervision and resolution of banks, is aimed at severing this part of the doom loop. Yet the other leg of the loop, where stress in the government bond market is transmitted to the banking sector, has thus far not been adequately tackled.3 The Five Presidents’ Report recommended that a review of the regulatory treatment of government debt should be considered, which essentially aims at severing this leg of the doom loop as well. However, the Five Presidents’ Report also stressed that this should be part of a global reform in this area, to avoid an uncontrolled unwinding of exposures to euro area government debt by non-euro area banks, and to prevent euro area banks being placed at a disadvantage towards their non-euro
Government debt receives favourable regulatory treatment, at the European as well as the global level.4 Because of this favourable treatment, and because of the role government debt plays in capital markets, government bonds are present on almost every bank’s balance sheet.
The largest share of government bonds is in most cases held in the form of domestic government bonds. Figure 1 shows that the share of sovereign debt held by domestic banks varies significantly between countries, and that the average for the euro area is very high at 57% and has been increasing since the beginning of the crisis.5
% of total government debt
Sources: Stress Test Data 2014, European Banking Authority. Consolidated Banking Statistics, Bank for International Settlement.Depository Institutions - Consolidated Balance Sheet, Board of Governors of the Federal Reserve System.
The average share of sovereign debt held by domestic banks in the euro area is not much higher than the average in the US of 45%, but varies very significantly from slightly more that 10% in Latvia to over 90% in Malta, reflecting factors like the size of the existing stock of national public debt and its attractiveness to non-national banks.
However, as Figure 2 illustrates, this home bias in government bonds results in a very significant concentration of counterparty risk in the euro area: the average euro area exposure to domestic government debt as a share of own funds is 118%, though again there is significant variation.6 In comparison, the exposure of US banks to US government bonds is significantly lower, at 14% of equity.
% of own funds
Hence, the status quo is such that in case of a default of a sovereign, the respective banks’ own funds would be wiped out. Even in the absence of a default, funding stress for any of these sovereigns is likely to significantly affect the banking sector as well, by forcing banks to adjust the amount of sovereign exposure in their balance sheets in ways that might constrain their profitability and capacity to extend credit to the broader economy.7 Hence further action at European level could be warranted, bearing in mind also the ongoing international discussions in this area.
There is a variety of policy options of how to respond to the observed concentration of government debt in the banking system.8 We focus on large exposure regimes as the policy to recommend, while outlining the advantages this solution has over other policy options discussed, most prominently capital requirements.
Capital requirements for counterparty risk aim to ensure that enough capital is left in a bank in case of the default of a counterparty, and vary with the probability of that happening. Currently, the Basel III rules allow for but do not require a capital requirement of 0% for sovereign debt.9 In the EU, the Basel Accord is transposed by the Capital Requirement Directive (CRD) and corresponding Regulation (CRR). Under European legislation a 0% risk weight is applied, under certain circumstances, to Member States’ debt issued in euro or local currency.10
It can be argued that in case where the credit rating of the counterparty is very good, the capital requirements are very small as a result and hence would do little to ensure the solvency of the bank in case of default. A considerable disadvantage of an approach based on capital requirements is that they are pro-cyclical.11 Namely, capital requirements tend to increase in a downturn, resulting in a bank being less able to lend and decrease in an upswing with the result of lending excessively in a boom. Also, the implementation of capital requirements for sovereign debt would probably result in very considerable market tension, and not only for euro area-based banks, as banks around the world would need to reprice their sizeable holdings of sovereign debt.12 Furthermore, banks would need to raise additional capital in order to comply with the new capital requirements. This would weigh negatively on their ability to lend to the real economy.
Large exposure regimes require banks and investment companies to limit their exposure to any single counterparty. Unlike the regulatory approach through capital requirements, the large exposure regime prevents the build-up of large exposures in the first place. The approach underlying this regulatory tool is hence a different one. Large exposure requirements disregard the likelihood of default or funding stresses and rather account for the occurrence of unforeseeable events, which can result in prohibitive losses even for the soundest counterparties. Exposure requirements carry the advantage that they are constant over the business cycle and are hence not pro-cyclical.13
In the EU, a large exposure limit is set at 25% of own funds.14 However, the EU’s Capital Requirement Regulation exempts exposures to sovereigns where these sovereigns would be assigned a risk-weighting of 0% under Basel’s ‘standardised approach’, which is effectively all the debt issued in local currency in the EU.15 As a direct result of this policy choice, which is by no means restricted to EU Member States only, government bonds are highly concentrated in most EU Member States’ banking systems. So far exposure limits have been reserved for crisis situations, as was the case with Greece earlier this year (see Wolff, 2015). Yet a large exposure requirement can contribute a large deal to a safer and more resilient banking system in the EU.
Option 1: Full or partial exemption from the large exposure regime: the full removal of the exemption for sovereign debt from the large exposure requirement would be the most straightforward option to sever the link between sovereigns and their banking sector. Another possibility would be to partially remove the exemption i.e. to account only for a certain share of the exposure (for example only 20% of the face or market value of the exposure). The threshold could be aligned with the 25% threshold currently applied in the Capital Requirements Regulations. Yet, this threshold is likely to be too low given the importance of the sovereign debt market for the functioning of European capital markets as well as the financing need of EU Member States. The exact limit to be set would need to carefully balance its regulatory aim and the role government debt plays in financial markets as well as the financing needs of euro area governments.16
Option 2: Exposure limits as a function of portfolio diversification: another option would be to make the exemption from the exposure limit conditional on the diversification of the government debt portfolio. The focus of this approach is rather on the diversification of the portfolio than on the actual exposure and in this way acknowledges that a well-diversified government debt portfolio is potentially less risky. Therefore, it could then be exempted from the exposure limit. A well-diversified portfolio could, for instance, be defined as a portfolio where the amount of debt held by any single euro area bank corresponds to that respective sovereign share in the euro area GDP (see ESRB, 2015).
The main disadvantage is that a well-diversified government debt portfolio can still be exposed to excessive counterparty risk because it does not exclude high exposure to any single government within the portfolio.17 Also, the crisis highlighted that there is a significant degree of contagion threat between euro area governments, because the exit of a Member States would threaten the credibility of the euro area as such.18 The market then prices such a scenario, leading to funding stress for vulnerable euro area Member States. As a result, even a well balanced portfolio with high exposure to the euro area can still constitute a significant risk to a bank.
Option 3: Exposure limits as a function of likelihood of default: another option would be to account for the different riskiness of government debt in calculating the exposure limits. In such a regime the permitted exposure to governments less likely to default would be higher than for those more likely to default. Yet such an option would not account for the very purpose of large exposure requirement i.e. that even the safest of all counterparties can experience a prohibitive unforeseen event, and it would also raise the question of how to assess the risk of a particular sovereign. The most obvious option to assess the likelihood of default are credit ratings. Yet, this would likely reinforce the systemic risk stemming from the so called ‘cliff effect’19 in credit ratings and be inconsistent with ongoing global efforts to reduce reliance on credit ratings.20 Also this policy option would introduce a certain element of pro-cyclicality as measures of creditworthiness are usually at least partly dependent on the overall business cycle, with credit rating being better in a boom phase and worsening sharply during a severe downturn.
Whichever way a large exposure regime for the euro area would eventually look like, it would require most banks to significantly reduce their exposure to those governments whose debt they hold in significant amounts. As illustrated above, this is mainly their respective domestic government. A well-designed phase-in period would need to be put in place in order to avoid market turbulence in the adjustment period.w1 Since government bonds continue to be high quality liquid assets, the institutions that have to reduce exposure to some governments are likely to substitute them with sovereign bonds from other governments.22 In this way, large exposure regimes encourage diversification of portfolios on a firm level and reduce systemic risk from a macro point of view (see ESRB, 2015).23
Largely reflecting EU and global policy choices, euro area banks are greatly exposed to their own sovereigns.
A straightforward exposure regime would greatly limit systemic risk in the banking system, result in a well-diversified government debt portfolio and considerably weaken the doom loop between sovereigns and their banking systems.25
A large exposure regime is the preferred policy option for the following reasons:
Any threshold would need to be carefully calibrated and account for the importance of the sovereign bond market for the functioning of wider capital markets and eventually for the funding of the real economy as well as of sovereigns. The exposure limit of 25% of own funds, as stipulated in the Capital Requirements Regulations, is unlikely to take these special circumstances adequately into account.
A large exposure regime, if introduced, would be placed with the ECB, the supervisory authority in the context of the Single Supervisory Mechanism. However, more wholesale changes in the regulatory framework (for instance, rethinking of the assessment of the riskiness of sovereign debt) would likely necessitate global discussions and agreements and should be pursued in the relevant international fora.