Simultaneously with the agreement on the revised capital framework for banks [link], the Basel Committee published a discussion paper about the regulatory treatment of sovereign exposures in this framework [link]. At this stage, the Basel Committee has not reached a consensus on taking further action.
Preferential treatment of sovereign exposures
The capital framework for banks currently sets less strict rules and lower capital requirements for sovereigns than for other assets held by banks. Since banks mostly apply a 0% risk weight for their sovereign exposures, they are not required to hold capital against them. No further restrictions are imposed on the magnitude of banks’ sovereign exposures, whereas exposures to private debtors must not exceed 25% of a bank’s eligible capital. Moreover, most sovereign bonds are considered the highest category of liquid assets without haircuts.
DNB believes this preferential treatment of sovereigns is undesirable. It is based on the misconception that government debts are risk-free and losses are inconceivable in practice. It also reinforces the interconnectedness of banks and governments, potentially causing contagion. This negative interaction was a key factor during the European sovereign debt crisis.
Exploration of policy options
The Basel Committee’s report identifies the role of sovereign debt in, and its effects on, the financial system. The report outlines several policy options for amending the regulatory requirements.
The first category of potential measures relates to abolishing internal risk rating models and increasing risk weights under the standardised approach. The removal of national discretions for debts issued by banks’ own national governments is another option in this category. The second category includes introducing marginal risk weight add-ons for the assets of banks with an increasing magnitude of sovereign exposures. The third category covers reinforcing monitoring, stress tests and more intensive supervision, and increasing the transparency of banks’ exposure to sovereigns.
Their purpose is to create balanced rules and regulations for government debts, providing for adequate pricing of risks and appropriate incentives for banks to diversify their portfolios and sovereign exposures. This will reduce the interconnectedness of banks and governments, thus promoting financial stability.
DNB welcomes the careful phasing out of the current preferential treatment of sovereign exposures in the capital framework for banks, preferably on a global level. The report sets out several useful strategies for doing so.
At this stage, however, the Basel Committee has not reached a consensus on changing the regulations. Sovereigns have a benchmark status in the financial system, often playing a more prominent role in many countries’ economies, which adds to the complexity of the debate and requires careful consideration of any reforms. The report nonetheless contains several key discussion questions inviting stakeholders to help guide the Basel Committee’s further development of ideas on this topic.
The interconnectedness of banks and governments was one of the determining factors in the European sovereign debt crisis. Now is the time to give new impetus to the discussion on a European level. Thanks to the ongoing development of the joint European banking supervision and resolution framework, banks are less likely to have to rely on support from their own governments. But as long as governments continue to turn to their own banking sectors for funding, the interconnectedness of banks and governments will not be resolved. This makes a careful and more balanced regulation of sovereign exposures a key element in the ongoing reinforcement of the functioning of the euro area. It is also one of the main features of the Ecofin Council’s roadmap, adopted in 2016 during the Dutch presidency of the EU, to further strengthen the banking union and set up a European deposit guarantee scheme.