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Post-financial crisis, banking watchdogs have regularly submitted banks to an examination of their assets to ensure they could withstand another shock to the global banking system. But the last two so-called stress tests failed to scrutinise banks' exposure to government bonds and despite criticism, regulators still cannot fully assess these holdings because international rules let banks consider them risk free.
The result, according to a new study that could have implications for the credibility of the latest bank tests, is that 64 of Europe's biggest banks may be holding a total of 806 billion euros ($1.04 trillion) of risk weighted assets that are linked to sovereign bonds - rather than the zero amount that regulators are counting on.
Risk weighted assets - gauging holdings according to their likelihood of default - matters because the capital requirements now demanded of banks post-financial crisis demand this rather than a simple balance sheet snapshot. The refinement was introduced by global banking watchdogs to make sure lenders were acknowledging their real risk profile and putting aside enough capital to cover any losses resulting from it.
In short, banks could pass the latest round of testing - the results are due to be announced in October - and still have "too little capital or at least too little excess capital (than if they had to recognise the sovereign risk)," said Prof. Sascha Steffen of Berlin's European School of Management and Technology (ESMT), author of the study with Dr Josef Korte of the Goethe University in Frankfurt.
The EU's treatment of banks' sovereign debt has been castigated by the committee of international watchdogs that drew up Basel, which intended to force banks to take a realistic assessment of risk in their holdings - but also allowed bonds issued by a bank's own country in the country's own currency to be considered risk free. The logic was that countries could print money to honour their own bonds, and likely would.
EU policymakers, with an eye on common market law, extended those rules to allow banks to treat as risk free any sovereign bonds issued by other EU countries. This was to encourage banks to hold high levels of government debt and provide a stable funding base for countries still grappling with massive deficits - and also ensure banks had a high supply of liquid assets, another objective of policy makers.
That, said Steffen, has created a situation that makes the financial sector riskier. As a group, banks are too heavily invested in sovereign bonds because they're all following the EU's incentives and because "banks do accumulate too much risk if they do not have to hold ...capital which reflects the economic risks".
An ECB spokesman said the ECB would not apply a "risk weighting" to sovereign bonds in its Asset Quality Review, an assessment that runs parallel to the stress tests, but added: "The stress tests...which are part of the exercise and which will be taken into account in banks' capital needs, no longer treat sovereign bonds as risk free."