A ‘sovereign subsidy’ – zero risk weights and sovereign risk spillovers

A ‘sovereign subsidy’ – zero risk weights and sovereign risk spillovers

Josef Korte, Sascha Steffen 07 September 2014

European banking regulation assigns a risk weight of zero to sovereign debt issued by EU member countries, rendering it an attractive investment for European banks. This column defines a ‘sovereign subsidy’ as a fresh measure quantifying from what extent banks are undercapitalised as a result of zero risk weights. Using recent sovereign debt exposure data, the authors describe the build-up of the subsidy for both domestic and cross-country exposures.

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Motivation

Policymakers and academics have recently began to address severe distortions due to just how banks are regulated in Europe. Just about the most apparent flaws in banking regulation may be the general application of zero risk weights for sovereign exposures. 1 Generally, Basel capital requirements stipulate that banks need to hold capital for all asset classes either predicated on confirmed regulatory risk weight or predicated on internally modelled default probabilities. However, this key notion of the Basel Accord is not followed in the administrative centre Requirements Directive (CRD) of europe. Consequently, EU banks usually hire a zero risk weight for sovereign debt and therefore usually do not hold capital against the sovereign exposures to EU member states. 2

This regulatory treatment of sovereign debt contradicts the spirit of the Basel accords (Hannoun 2011, Nouy 2012). Moreover, it creates investments in risky sovereign debt particularly attractive (Acharya and Steffen 2013, Battistini et al. 2013). If sovereign risk materialises (as happened in the European sovereign debt crisis), banks might experience a considerable capital shortfall and may even require capital backstops by their domestic sovereigns.

We quantify the dimension of capital savings because of zero risk weights. Moreover, we discuss the economic implications connected with this regulatory treatment since it can be an important determinant of the co-movement of sovereign CDS spreads within the Eurozone.

Bank level exposures to sovereign debt

The European Banking Authority (EBA) has conducted several assessments of banks’ exposures towards sovereign debt and capitalisation over the March 2010 to June 2013 period. After 2 stress tests this year 2010 and 2011, the EBA continued to assess EU banks also to disclose a large amount of data in order to increase transparency regarding the solvency of the European banking sector. The info comprise individual sovereign bond holdings of 62 major European banks (91 in earlier tests) at seven reporting dates. As exposure data are for sale to only 54 banks throughout total reporting dates, we measure the development of sovereign exposures because of this subsample. 3

Figure 1 . European banks’ sovereign exposure

Figure 1 demonstrates the sovereign exposure of the 54 largest European banks amounted to €1.5 to 2 trillion during the last four years. Interestingly, the sovereign exposure of the banking sector didn’t decrease but instead increased as the sovereign debt crisis unfolded. The exposure isn’t just significant in absolute euro amounts, but also comparing it to the tier 1 capital of the respective bank. Typically, sovereign bond exposures take into account a lot more than 200% of banks’ tier 1 capital. Some banks have even sovereign exposures as high as 15 to 20 times their regulatory capital. Interestingly, non-domestic sovereign debt accocunts for between 40 to 50% of total sovereign exposures on European banks’ balance sheets.

High exposures to domestic and non-domestic sovereigns isn’t just a phenomenon of banks in a few countries. The entire development of banks’ sovereign exposure in addition to the share of non-domestic sovereign debt, however, is quite different for banks situated in the GIIPS (Greece, Italy, Ireland, Portugal, and Spain) or core-European countries. As Figure 2 shows, banks in peripheral countries increased their exposures by around 50% since 2009, mainly driven by domestic sovereign debt that makes up about approximately 80% of total exposures. Banks from the non-GIIPS countries didn’t significantly increase their exposures as time passes and have a much bigger share (around 50%) committed to non-domestic sovereign bonds.

Figure 2 . Sovereign exposure of non-GIIPS banks

Figure 3 shows the exposure of the 10 largest GIIPS and non-GIIPS banks by March 2010 (Panel A) and June 2013 (Panel B). We plot the banks’ exposure as a share of tier 1 capital against their cross-border exposure as a share of total exposures. GIIPS banks have significantly more domestic exposure and higher exposure in accordance with tier 1 capital. Non-GIIPS banks, on the other hand, hold a lot of cross-country sovereign debt with still high exposures in accordance with tier 1 capital. Large banks from core countries such as for example Germany and France hold sovereign exposures exceeding 100% of their tier 1 capital. Panel B of Figure 3 implies that GIIPS banks increase domestic sovereign bond exposures in keeping with a rise in ‘home bias’ of GIIPS and non-GIIPS banks; also non-GIIPS banks substantially reduce their cross-country exposure but exposures overall remain high in accordance with tier 1 capital.

Figure 3 , Panel A. Sovereign exposures by March 2010

Figure 3 , Panel B. Sovereign exposures by June 2013

The sovereign subsidy

In Korte and Steffen (2014), we propose a fresh measure that quantifies the sovereign subsidy because of zero risk weights. We assign risk weights to each sovereign exposure and compute the corresponding risk weighted assets that aren’t adequately reflected in the banks’ capital. We call the latter the ‘sovereign subsidy’ and use alternative solutions to compute the correct risk weights for the sovereign exposures. Our main measure is comparable to the EBA stress test methodology and uses the rating of a country, the corresponding possibility of default, and the Basel method of compute risk weights for sovereign debt.

Constructing this measure for the 54 banks which were part of most EBA exercises (Figure 4), we document that subsidy accumulates to approximately €750 billion by June 2013. This corresponds to almost 100% of banks’ tier 1 capital, typically – an exposure that’s not adequately reflected in banks’ capital position! Figure 4 also implies that the sovereign subsidy has nearly doubled during the last four years. That is only in part because of increasing sovereign exposures, but mostly driven by deteriorating sovereign credit risk and correspondingly increasing risk weights.

Figure 4 . Sovereign subsidy

The EBA published the RWA that banks report for his or her sovereign debt exposure for Q4 2012 and Q2 2013. Predicated on this, we calculate the ‘actual risk weights’ that banks connect with sovereign debt. Normally, this risk weight is 1.4%.

Zero risk weights and contagion within the Eurozone

As the sovereign subsidy considers risks that aren’t adequately reflected in a bank’s capital, it measures a potential capital shortfall if the creditworthiness of a country deteriorates. A bank with a more substantial non-domestic sovereign subsidy may thus need a larger public backstop by its respective government.[4]

Therefore, as domestic banks’ non-domestic sovereign exposure increases or becomes riskier, so does the contingent liability of the domestic sovereign. Consequently, a sovereign’s risk isn’t just immediately from the threat of other EU sovereigns through the CDS market and other linkages, but also through the (implicit) bailout guarantees of the sovereign because of its domestic banking sector. Zero risk weights thus create a channel by which sovereign risk could be transmitted among EU member states.

Inside our recent paper, we document that changes in a value-weighted non-domestic European Sovereign CDS Index indeed co-move with changes in sovereign CDS spreads. Moreover, this co-movement is amplified the bigger the (non-domestic) sovereign subsidy of a country’s domestic banking sector is, in keeping with larger expected bailout costs in the event of a sovereign default. These results hold controlling for other determinants of CDS spread changes, bond yield changes as alternative measure for sovereign risk, aswell as for credit scores and CDS implied sovereign subsidy measures. In addition they hold when controlling for alternative channels of sovereign risk spillovers, such as for example mutual bailout responsibilities and other linkages between member states. Exploring exposures to non-EU members as a falsification test, we find an insignificant aftereffect of the sovereign subsidy on sovereign CDS spreads. Moreover, we find that the result also becomes insignificant for non-domestic exposures to EU member states following the September 2011 capital exercise by the EBA when banks were necessary to build-up a sovereign capital buffer.

Closing the sovereign gap

Using recent EBA data, we document that domestic and non-domestic sovereign exposures are a significant phenomenon for banks across Europe. Current regulatory capital requirements, however, leave banks severely under-capitalised given the riskiness of their sovereign bond portfolios which amplifies risk spillover within the Eurozone and escalates the implicit bailout costs of the banking sector.

The implementation of Basel III through the CRD IV will not try to adequately address this issue. However, the excess capital requirement of sovereign debt holdings that is introduced by the EBA’ capital exercise in September 2011 is actually a first rung on the ladder in this direction. Adequate risk weights for sovereign debt ought to be applied and become part of prudential capital regulation. As there exists a large contingent capital shortage because of the zero risk weight, replacing it for a far more risk-adequate treatment of sovereign exposures would probably require yet another capitalisation effort for banks and extra sovereign backstops.

References

Acharya, V, R Engle, and D Pierret (2014), “Testing Macro-prudential Stress Tests: THE CHANCE of Regulatory Risk Weights”, Journal of Monetary Economics, forthcoming.

Acharya, V, and S Steffen (2014), “The ‘Greatest’ Carry Trade Ever? Understanding Eurozone Bank Risks”, Journal of Financial Economics, forthcoming.

Battistini, N, M Pagano, and S Simonelli (2013), “Systemic risk, sovereign yields and bank exposures in the Euro crisis”, Unpublished working paper.

Hannoun, H (2011), “Sovereign Risk in Bank Regulation and Supervision: Where Do We Stand?” Conference contribution, Financial Stability Institute High-Level Meeting, Bank for International Settlements.

Korte, J, and S Steffen (2014),“Zero Risk Contagion – Banks’ Sovereign Exposure and Sovereign Risk Spillovers”, Working Paper.

Nouy, D (2012), “Is Sovereign Risk Properly Addressed by Financial Regulation?” Financial Stability Review (16), pp. 95-106.

Endnotes

1 There are other benefits connected with holding sovereign debt (for instance, no exposure limits). We usually do not discuss those inside our paper.

2 Beneath the standardised approach, the CRD stipulates a zero risk weight for exposures to the European Central Bank also to member states’ sovereign debt issued in the domestic currency of this member state. While banks that utilize the IRB approach theoretically need to hold capital against sovereign exposures, Nouy (2012), for instance, shows the IRB approach will not necessarily create a positive risk weight for sovereign exposures. The likelihood of default (PD) put on sovereign portfolios isn’t at the mercy of a floor (unlike the PD for other exposures). Hence, the IRB approach you could end up a zero risk weight for sovereign exposures. Importantly, banks may also choose to change to the standardised approach when assessing the administrative centre requirements because of their sovereign debt portfolio following IRB permanent partial use – an exemption which banks usually operating under IRB indeed make frequent usage of. Hence, almost all banks eventually employs a zero risk weight for sovereign debt and therefore will not hold capital against the sovereign exposures to EU member states.

3 As they are the biggest banks in Europe, our subsample usually accocunts for a lot more than 90% of the exposures in every banks that formed section of the EBA exercises.

4 To the extent that there surely is a credible TBTF guarantee, the sovereign subsidy may very well be a put option on the sovereign’s creditworthiness with a strike price at the facial skin value of the exposure.

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