Acting now before the inevitable storm – The sovereign-bank nexus

Dino Kos explores why it is the right time to address the regulatory treatment of sovereign exposures.

The regulatory treatment of sovereign exposures is not a new issue. The Basel Committee struggled with the subject going back to the initial Basel Accord in the late 1980s. Back then, the question was whether some or all sovereign exposures should be zero risk weighted. More recently, the inadequacies of the current approach have been linked to the “sovereign-bank nexus” and again elevated this issue to the forefront of the post-crisis policy debate.

The result was a flurry of activity by international standard- setting bodies and experts, but the full scope of the issue has yet to be resolved. Notably, notwithstanding years of work, in 2017 the Basel Committee could not reach consensus on how to change the regulatory treatment of sovereign exposures. A public consultation never left the door. The Basel Committee’s discussion paper on sovereign risk labeled proposed changes to the regulatory treatment of sovereign exposures as “potential ideas” rather than “recommendations”. Capital regulations continue to allow preferential treatment of sovereign exposures. 

Current benign environment is a window of opportunity to act before the inevitable storm moves in

While addressing the sovereign-bank doom loop is difficult, promising ideas have been put on the table. Some combination of adjusting risk weights, and, more importantly, adopting concentration limits on sovereign holdings, provides a way forward to reduce this risk over time. What is required is urgency and action. So what is holding back progress now – nearly a decade since the onset of the Greek crisis that first elevated this risk?

Ironically, market pressure has eased as the demand for sovereign debt has surged. Thirteen EU Member States, plus Switzerland and Japan, have negative yield on government debt securities with maturities of up to five years. Many of these have negative yields out to 10- year maturities. 

Governments have no difficulty financing themselves and have taken advantage to issue large amounts of debt, despite an overall deterioration in sovereign ratings.  As sovereign yields have fallen, so have borrowing costs for banks. In the short-run, negative yields relieve the pressure to act.  As yields have gone deeper into negative territory, the value of the bonds banks hold has increased – and is actually helping balance sheets – for now.

However, in the medium- to long-run, the current negative rate environment is unlikely to persist. Any number of factors could cause a reversal. The market is increasingly like a coiled spring that, when released, could set off a rapid and disruptive upward lurch in bond yields. 

The time to address the regulatory treatment of sovereign exposures is now. Not only are proposed solutions out there, but the current benign environment provides a window of opportunity to act before the inevitable storm moves in.  As JFK once said, “There are risks and costs to a program of action. But they are far less than the long-range risks and costs of comfortable inaction.”

The views outlined in this article are my own, and do not reflect the views of CLS.

First published in “Views – The EuroFi magazine”, September 2019

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