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Emerging Markets

Basel — faulty for sovereigns?

At a time of unprecedented stress in sovereign bond markets, European regulators aren’t doing much to ease the strain on banks — one of the sector’s most important investor bases. Tessa Wilkie reports.

  • 13 Dec 2011
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As the sovereign-bank feedback loop intensifies by the day, Europe’s bank regulators are struggling to stabilise the financial sector, forcing through speed recapitalisations and bringing in measures to avoid a repeat of the last four years of crisis. Yet regulators risk moving too quickly, damaging banks — and thereby losing a key supporter of sovereign debt.

Now that the banking crisis has evolved into a sovereign crisis, the regulators should reconsider their time schedule for putting out old fires, because if they go too far they risk bringing down much bigger structures than banks.

European banking regulation has in the past encouraged banks to hold sovereign paper. For example, Capital Requirements Directive II has allowed banks to assign a risk weight of 0% on exposures to EU member states’ government debt denominated in their home currency.

But upcoming regulation will make it more punitive to hold sovereign paper. Basel 2.5 will increase capital requirements for positions in the trading book, and both Basel 2.5 and Basel III will increase the financing costs of swap agreements with counterparties.

On top of that, Europe’s regulators heaped yet more pressure on the banks in October, telling financial institutions to build a temporary capital buffer against sovereign debt exposures marked to market prices. The European Banking Authority (EBA) is overseeing the remarking and setting rules for banks to reach a core capital ratio of 9% by the end of June 2012.

Banks’ message to the regulators is: slow down. They warn that grim consequences could emerge from an inability to react proportionately. "Trying to push through all of this regulation at the same time is causing uncertainty. In this environment, banks need to get their footing from a liquidity and capital perspective," says Spencer Lake, co-head of global markets at HSBC in London.

The speed at which these measures are being introduced is contributing to the wider problems in the Eurozone. "The appetite for European risk, whether it’s public or bank-related private sector, is eroding," says Lake. "Money is being extracted and held in cash or invested elsewhere in either higher certainty or higher growth environments. That is hurting the overall fabric of Europe."



Zero risk no longer?

On top of the call to mark sovereign bonds to market, the Greek private sector involvement scheme will involve hefty haircuts on these sovereign bonds.

"We have now a situation where banks suddenly face a ‘voluntary’ haircut, where before they were more or less forced by the regulators to hold sovereigns for liquid asset purposes," says Frank Will, senior strategist at Royal Bank of Scotland in London.

European regulation has encouraged banks to hold sovereign paper for risk-weighted asset and liquidity purposes. Under the Basel II standardised approach sovereign paper that is rated AA- or above carries a zero risk weighting. European capital requirements directives took that further with a generalised zero risk weighting for member states’ central government debts that are denominated and funded in the domestic currency of a central government.

"Even Greece at the moment has a zero risk weighting under the standardised approach," says Will.

While sophisticated banks are encouraged to use an internal ratings-based (IRB) approach under Basel II, those in Europe can use IRB permanent partial use rules.

The permanent partial use approach allows banks to apply the internal ratings-based approach for corporate, mortgage or retail exposures, but then use a zero risk weight for the sovereign debt of EU member states.

According to the Committee of European Banking Supervisors, the EBA’s predecessor, in 2006, the permanent partial use ruling allows banks to be permanently exempted from applying the IRB to central bank and central government exposures if it would be "unduly burdensome" for the bank to implement a rating.

This practice is widespread. Out of the 90 banks that were involved in the 2011 European stress test, 59 were using the IRB but 23 banks used the zero risk weighting for their sovereign paper.



Primary dealership pain

The introduction of Basel 2.5, through the Capital Requirements Directive III in Europe, is putting a strain on primary dealerships at a time when they most need to support their sovereigns. McKinsey, a consultancy, found that the new market risk framework, part of Basel 2.5 and due to come into force on December 31, will more than double the capital requirement to support risk-weighted assets (RWA) in the trading book.

It made the findings in a report looking at the effect of new regulation on the world’s 13 largest banks.

"The increase in RWAs comes from additional capital charges for stressed value at risk (VAR) for all products, as well as the incremental risk charge (IRC), a new securitisation charge, and the comprehensive-risk measure (CRM) for credit and rates products and proprietary trading," say the McKinsey authors.

For one thing CRD III increases the risk-weighted assets held on trading books. For example, even sovereign bonds with a zero risk weighting should incur an incremental risk charge — requiring banks to hold more capital against bonds in the trading book. This has been a factor in causing banks to sell at a time when sovereign paper trading is highly volatile.

"That was material for a lot of sovereign positions and other trading book holdings," says Glenn Leighton, head of balance sheet advisory at Barclays Capital in London. "A lot of banks have announced mitigating actions, which is selling them over time. If you’re in a falling or a volatile market environment, and you’re being whacked with increased capital because of Basel 2.5, all else being equal that’s not a helpful factor."

Where banks once used to hold sovereign bonds as a liquidity buffer, now in some cases they are assets to be unloaded as they try to improve their capital ratios. This is not helping sovereigns’ primary dealerships, which is only going to hurt sovereign borrowing itself.

"It clearly creates a conundrum for the big banks because the way that sovereigns have funded themselves through their primary dealerships over the course of time has been via heavy participation by the primary dealers to underwrite primary offerings and make secondary markets for the clients," says Lake at HSBC. "CRD III and CRD IV are forcing more discipline on capital usage, and that has a significant cost associated with it."

Another issue, slightly further ahead, that banks are going to have to deal with is how Basel III tackles derivative exposure. Basel III, which starts being implemented from 2013, introduces credit valuation adjustments (CVAs) which require banks to hold more capital for counterparty risk. McKinsey estimates that the market risk framework will result in the current counterparty credit risk charge increasing by a factor of 2.5, driven by the CVA charges, among other things.

Banks could face much more expensive financing for swaps, which they may have to pass on to borrowers, for example by insisting upon two way credit support annexes (CSAs), something that top quality SSA names have largely been able to bypass thus far.

"Suddenly all these previously exempted public sector exposures can have a huge impact on your RWA," says Kentaro Kiso, head of global medium term notes and public sector coverage at Barclays Capital in London. "Some banks will not quote long-dated cross-currency swaps, it doesn’t matter whether it is public sector or a corporate, as long as they are not covered by a two way CSA, they simply don’t quote."



Enough eligible liquid assets?

Incoming liquidity rules are also making life difficult for banks. Basel III, with its definition of eligible liquid assets, encourages banks to hold cash or government bonds in their own currencies.

In the UK a form of this regulation has already been introduced, making government bonds arguably disproportionately expensive for other investors.

"In the UK there have been very substantial purchases by banks to increase their holdings in Gilts," says David Miller, partner at Cheviot Asset Management in London. "It’s more than trebled. It’s an extremely powerful influence on price."

Many feel that these prescriptions are too narrow, particularly where sovereign bonds can now no longer count as risk-free assets.

Previously eligible assets have been cut out, in reaction perhaps to the crisis which engulfed the securitised bond markets in the period between 2007 and 2009.

The new regulations make securitisations such as residential mortgage backed securities ineligible as a high quality liquid asset under the liquidity coverage ratio. Covered bonds can qualify but are subject to a haircut and banks are subject to limits on the amount they can hold to qualify. But some argue that the eligible assets allowed should be broader, and that triple-A rated securitisations should be allowed too.

"The removal of triple-A asset backed securities from the liquid asset pool is really making it a lot more difficult than it should be," says Leighton at BarCap. "If banks could buy each other’s ABS that could get the secured bank funding markets going again. The covered bond market can’t absorb all of this stuff. There’s a funding wall, we need ABS to function and eventually you need senior unsecured to function."

While the existing regulations perhaps do not reflect the risks of sovereign debt holdings properly, regulators ought not to be too harsh on the banks at a time of such volatility in the sovereign bond markets — they should beware of kicking away the supports when the whole system is wobbling.
  • 13 Dec 2011

Bookrunners of International Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
1 Citi 17,937.65 77 10.67%
2 HSBC 17,202.71 88 10.24%
3 JPMorgan 15,720.00 64 9.35%
4 Deutsche Bank 13,208.40 58 7.86%
5 Bank of America Merrill Lynch 10,749.43 54 6.40%

Bookrunners of LatAm Emerging Market DCM

Rank Lead Manager Amount $m No of issues Share %
1 HSBC 6,221.38 14 11.59%
2 JPMorgan 5,140.67 18 9.58%
3 Bank of America Merrill Lynch 4,497.27 18 8.38%
4 Deutsche Bank 4,264.56 14 7.95%
5 Credit Suisse 4,132.73 8 7.70%

Bookrunners of CEEMEA International Bonds

Rank Lead Manager Amount $m No of issues Share %
1 Citi 6,674.27 20 14.95%
2 JPMorgan 5,884.96 16 13.18%
3 Barclays 4,728.57 10 10.59%
4 Deutsche Bank 4,044.06 10 9.06%
5 Goldman Sachs 3,229.17 5 7.23%

EMEA M&A Revenue

Rank Lead Manager Amount $m No of issues Share %
1 Goldman Sachs 182.99 41 13.58%
2 Bank of America Merrill Lynch 90.70 28 6.73%
3 JPMorgan 88.18 43 6.54%
4 Deutsche Bank 85.13 29 6.32%
5 Lazard 80.06 43 5.94%

Bookrunners of Central and Eastern Europe: Loans

Rank Lead Manager Amount $m No of issues Share %
1 ING 382.49 5 8.60%
2 Commerzbank Group 292.65 4 6.58%
3 UniCredit 275.33 3 6.19%
4 SG Corporate & Investment Banking 271.81 3 6.11%
5 Raiffeisen Bank International AG 207.65 3 4.67%

Bookrunners of India DCM

Rank Lead Manager Amount $m No of issues Share %
1 Standard Chartered Bank 1,072.16 12 9.37%
2 Deutsche Bank 1,008.26 15 8.82%
3 AXIS Bank 1,000.88 27 8.75%
4 Barclays 699.87 9 6.12%
5 Trust Investment Advisors 698.72 32 6.11%