Breakingviews:UK’s sovereign debt precaution at odds with EU

Fri May 10, 2013 2:06pm IST

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(The authors are Reuters Breakingviews columnists. The opinions expressed are their own)

By Peter Thal Larsen and George Hay

HONG KONG/LONDON, May 10 (Reuters Breakingviews) - Britain’s principled approach to banks’ holdings of sovereign debt could have a perverse outcome. The watchdog has taken the sensible step of demanding that lenders expect big losses if government bonds default. That helps fix one of the biggest flaws in measuring bank capital. But pan-European rules mean that risky euro zone debt is excluded from the precautions.

The proposals, outlined by the Bank of England’s Prudential Regulation Authority in March, aim to fix one of the most contentious areas of measuring bank capital: the treatment of government bonds. For years, regulators treated all sovereign debt as if it was all low-risk. The euro zone crisis has exposed the folly of that approach.

But even new Basel III capital rules don’t fully address the problem. That’s because big banks calculate risk on the basis of past experience, and sovereign defaults are still rare. The danger is that government bonds will continue to receive lenient treatment. That would further confirm investors’ suspicions that bank capital ratios cannot be trusted.

So the PRA has stepped in. It says banks should assume that sovereign bonds will lose at least 45 percent of their value in a default. Plugging this figure into risk models will raise RWAs and reduce capital ratios. HSBC’s RWAs were $19 billion higher at the end of the first quarter as a result of the shift.

The problem is that the PRA’s approach is at odds with the European Union’s interpretation of Basel, which states that all bonds issued by European Economic Area governments in their local currency should receive a zero risk weighting. Under the EU’s "maximum harmonisation" provisions, Britain is not allowed to toughen up the rules by itself.

It’s not the first time Britain has run into this problem: the UK government’s plans to make banks hold bigger capital buffers has also met with resistance from Brussels. Unless Britain can persuade its European partners to adopt its approach, risky sovereigns like Portugal, Spain and Italy are excluded from the PRA’s new rules, while U.S. Treasury bonds aren’t. That gives UK banks an incentive to hold more euro zone debt, and penalises those lenders with large operations in other parts of the world. A sensible policy looks to be creating a perverse outcome.

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CONTEXT NEWS

- HSBC on March 7 reported that risk-weighted assets increased by $19 billion bin the first quarter of 2013 as a result of changes to risk models imposed by UK regulators.

- The changes affect the way banks calculate the riskiness of sovereign debt they hold. The Bank of England’s Prudential Regulation Authority said in a consultation document published in March that it wanted banks to assume government bonds would lose at least 45 percent of their value in the event of a default.

- Imposing a higher Loss Given Default increases the risk-weighting that banks apply to holdings of government bonds. This raises their risk-weighted assets (RWAs) – a key part of the measure of bank capital – and makes capital ratios appear lower than under the previous approach.

- However, the PRA’s approach clashes with the European Union’s Capital Requirements Directive, which states that bonds issued by governments in the European Economic Area should carry a zero risk weighting.

- Under a provision known as "maximum harmonization", member states are prevented from adding their own extra safety to EU rules.

- HSBC’s total risk-weighted assets at the end of March were $1,098 billion, down from $1,124 billion at the end of December.

- Standard Chartered said in its 2012 annual report that the changes increased its RWAs by $3.5 billion by December 2012.

- HSBC first quarter results: link.reuters.com/gyf97t

- UK Prudential Regulation Authority consultation paper: link.reuters.com/fyf97t - For previous columns by the author, Reuters customers can click on [LARSEN/]

(Editing by George Hay and David Evans)

((peter.thal.larsen@thomsonreuters.com))

((Reuters messaging: george.hay.thomsonreuters.com@reuters.net)) Keywords: BREAKINGVIEWS DEBT/

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