EU to deal with sovereign debt

EU to deal with sovereign debt

After the election of a Eurosceptic populist government precipitated a sharp sell-off of Italian debt over the summer, concern once again rose about the “doom loop” between under-pressure eurozone economies and their closely linked banking systems. Financial Times reports in its article Policymakers urge action on EU sovereign debt ‘doom loop’ that Danièle Nouy, the eurozone’s chief banking regulator, and Olivier Guersent, the European Commission official responsible for financial services, are calling for this to be addressed urgently.

Banks may hold a limitless amount of EU government bonds on their balance sheet with no capital requirements because the assets are assumed to be so safe they carry a “zero” risk weight. As a result, banks have accrued large stockpiles of the debt, particularly of their home nation for political reasons.

However, the bonds have repeatedly proved risky and in times of crisis can be volatile, for example in Greece in 2015 and Italy this summer. When debt prices fall and yields rise, banks are forced to reprice their holdings and may have to reduce lending and raise capital to survive, further undermining the health and stability of their home country.

Ms Nouy, the departing head of the European Central Bank’s Single Supervisory Mechanism, said it was vital that banks’ capital regimes should reflect the risks they were taking when they held the sovereign bonds of less secure countries and ditch the “zero risk weighting” assumption that applied across the board.

“Legislators have to take responsibility” and must act urgently, she told the Financial Times. “Risk-weighted assets [should be] based on the quality of the sovereign [and] on the concentration. [On] the two elements . . . there are things that can be done and it should be done smoothly.”

Italian banks are the most exposed in Europe, holding €387bn of domestic sovereign debt — equivalent to about 10 per cent of their total assets, according to data from the ECB. The country’s two largest lenders, Intesa Sanpaolo and UniCredit, have exposures larger than the amount of capital on their balance sheet designed to absorb losses.

Concern about banks’ exposure to Italy’s persistently elevated public debt — more than 130 per cent of gross domestic product — has persisted, although investors have welcomed a deal struck between Rome and Brussels on Wednesday over Italy’s budget plans for 2019. The commission had previously complained that Italy’s plans were an unprecedented breach of EU spending rules.

It is not just Italian banks at risk. There are fears of continent-wide contagion as insurance companies and other lenders across the eurozone also own tens of billions of Italian bonds.

“When the situation in the markets becomes more tense it’s a natural tendency at national level that the doom loop re-initiates,” said Mr Guersent, the commission’s director-general in charge of financial services policy. “That’s one of the reasons why . . . the eurozone will have to think about concentration charges above a certain level of retention of the home sovereign.”

Germany’s Bundesbank has repeatedly urged regulators to impose limits on the amount of their own government’s bonds that banks can hold on their balance sheet. The German central bank views the weakening of the sovereign-bank nexus as vital for a more solid eurozone banking union, and is reluctant to back measures such as a Europe-wide insurance scheme for deposits without such limits.

Regulators will have to overcome political opposition. Limiting sovereign exposures is unpopular in highly indebted countries because their governments do not want to give up the stabilising role that domestic banks play by purchasing their bonds in times of crisis, Isabel Schnabel, a member of the German Council of Economic Experts, said in an opinion piece in the FT in August.

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Vestnik Kavkaza

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