The publication last Sunday of the BIS (Bank for International Settlements) annual report slipped under the radar amid the aftermath of the UK’s Brexit referendum result two days earlier, yet it may well have released another - not entirely unconnected - bombshell for banks.
According to BIS, the “current prudential treatment of sovereign exposures is no longer tenable” and it has become “essential to move away from the present favourable treatment of sovereign exposures in bank regulation to a framework that more accurately reflects sovereign risk”.
Soon after the report was published, S&P followed Moody’s decision on the day of the referendum result to reduce the UK’s credit rating from the top tier to the second division on their global scale.
Reflecting on the 2008 GFC, the report cites a “doom loop” wherein sovereign and financial system risk reinforce one other. This phenomenon includes sovereign debt and bank CDS (credit default swaps) moving in lockstep, and a tighter correlation between the two in countries with weak finances, according to BIS.
“Similarly, weaker banks, as measured by market-to-book ratios, are associated with higher public debt. Furthermore, the two-way contagion is stronger for countries with a larger financial sector and a higher share of bank-intermediated finance,” the report adds.
This is a relatively new phenomenon, according to BIS. When the GFC broke in 2008, it notes, banks’ solvency risk as measured by CDS spreads spiked, but sovereign risk did not. Then, after banks were bailed out and given government guarantees, the CDS spreads fell, and sovereign risk subsequently went up.
“And when the euro area crisis broke out in 2010, the co-movement increased strongly in stressed countries. Confronted by high debt and a lack of fiscal space, financial market participants viewed risks as intertwined,” it adds.
Yet sovereign debt currently enjoys strongly preferential treatment under global regulations, including the Basel capital framework’s standardised approach; some national authorities allow a lower or even zero risk weight so long as the sovereign in denominated in the local currency. Similarly, under an internal ratings-based approach, banks are able to give sovereign exposure a close-to-zero risk weight.
BIS also suggests sovereign exposure could pose concentration risk, as it is exempt from a requirement that banks expose no more than 25 percent of their eligible capital to any single counterparty or group of connected counterparties.
According to the report, eliminating these favourable treatments would discourage banks from building up large exposure to domestic sovereign bonds, thereby reducing “moral hazard” for both them and regulators, and make lenders better capitalised to withstand market turmoil.
“These factors should promote both better risk management and greater macroeconomic resilience, not least by attenuating the ‘doom loop’. This could ultimately translate into lower long-term funding costs for both banks and the government. Moreover, by reducing distortions among asset classes, it could also increase the supply of credit to private non-financial corporates,” it adds.
There are caveats to the BIS’s view, however, as it notes tougher regulation of sovereign debt exposure could prevent banks from acting as contrarian investors during market stress, and bond market liquidity could decline even when there is no stress: “Regulatory capital charges on government securities may increase bank intermediation costs in both the cash and repo markets for sovereign securities, as dealers reduce inventories. Yet, if banks become more resilient and market stress less likely, market liquidity should become more robust and central banks would have to provide emergency liquidity less frequently.”
Regulating to reduce sovereign bond exposure could also prevent banks from using rate arbitrage in the repo market, “hence weakening the impact of policy rate changes on long-term yields”, it adds, but overall should reduce average interest rate volatility by improving their resilience.
And stricter treatment of sovereign debt could disproportionately hurt less developed financial systems, according to BIS, as their banks tend to have less room to diversify domestically, and would expose themselves to currency risk, and hedging costs, if they look offshore for the required diversification.
Changes to the current treatment would have to take into account how to measure sovereign debt riskwith some regulators already having outlawed the use of rating agencies to calculate regulatory requirements; the type of regulatory instrument used, be that risk weights, exposure limits, or a combination of the two; and last but not least “the consistency of credit risk regulation with the treatment of other risks”.
On the latter point, BIS suggests sovereign bond exposure could be moved from the banking book, where it currently resides, to the trading book, which would “address both inconsistencies and would help to better align banks' risk-taking incentives, albeit at the cost of potentially larger reductions in capital at times of sovereign stress.”