FT.com/Alphaville: An MEP out to risk-weight the eurozone

04 April 2011

"To spot the next source of financial instability simply identify the assets currently considered 'safest'. At the moment we’d argue those are covered bonds, and of course, sovereigns. The first hasn’t gotten much regulatory scrutiny of late but the second, well, there are some capital games afoot."

For instance, we know the European Commission is considering ditching zero per cent risk-weights when transposing the upcoming Basel III into EU law, and default risk capital will also be introduced for all trading book positions under Basel’s already-agreed trading book rules. But there’s another push.

You see, there’s this woman. An MEP called Sharon Bowles.

Risk’s most-excellent Duncan Wood reports on Friday that Bowles has added some amendments to European Parliament text to remove the zero per cent risk-weighting on sovereign bonds.

Controversial, sure. But there’s something very intuitive about introducing default risk on assets which no longer seem very risk-free. As a reminder, government bonds currently held in banks’ trading books are assumed to be default risk-free and only attract capital to cover interest rate risk.

In the banking book, where most of European banks’ exposure to peripheral government bonds actually lies after last year’s stress tests, debt rated AA- or better requires no capital at all, and regulators typically allow banks to hold zero capital against bonds issued by their own government.

But that could change quite swiftly. Back to Wood, and Bowles: In mid-February, Sharon Bowles, a UK member of the European Parliament (MEP) and chair of the parliament’s influential Economic and Monetary Affairs Committee (Econ), proposed removing the 0% risk-weight – the multiplier that is the ultimate determinant of banking book capital – as a way of disciplining unruly issuers.

“Part of the reason we have problems in the banking system – and part of the reason Germany is having to carry out a sovereign debt rescue – is that banks are sitting on lots of Greek debt. And at a time when rates on that debt were escalating, banks were buying it because they didn’t have to make any provision against it and could also go and repo it at the European Central Bank and get their money back. That was a nice little earner when compared with buying the debt of another country,” she says.

Removing the 0% risk weight for troublesome EU countries would head off that kind of arbitrage, she argues – but Bowles is only proposing the mechanism should be applied to eurozone countries.

“The underlying assumption of the 0% risk weight is that, if the worst comes to the worst, you just print more money. But in a currency union, you can’t do that – and it’s been known since the start of the euro that there is a false assumption here. People did point it out, but others thought we wouldn’t actually get to the point where it would be tested. But we have,” she says.

Bowles talks some sense — but of course the talking is easier said than actually doing.

If government bonds are no longer the safest assets around, then we’re betting something else will eventually replace them (and it’s worth noting here that some covered bonds are already trading through their sovereign equivalents). Meanwhile differentiating between government bonds –officially creating a tiered approach to sovereign risk-weightings — might not win many fans in Europe right now:

… traders hope significant change in the capital regime would be too sensitive to contemplate – for now, at least. “They can’t afford to create that kind of shock. They wouldn’t want French banks suddenly dumping their Italian bonds. I’m not sure it’s in the spirit of European politics at the moment,” says one London-based head of European rates.

© Financial Times