Capital requirement changes would encourage banks to sell sovereign debt, says report

EU finance ministers held discussions in April on proposals to bring in capital requirements and exposure limits, according to Fitch. The changes would aim to reduce banks' exposure to risk, as part of measures to strengthen Europe's banking union.

Banks could be forced to either increase the capital they hold by as much as €135 billion, or 'reallocate' €492 billion in sovereign debt, Fitch said.

Fitch looked at different scenarios based on options already publicly considered by EU officials.

Capital requirements depend on the level of risk associated with a bank's debt. As part of the calculation of these requirements, the value of the debt is multiplied by a 'risk weight' that reflects its risk level. Low risk assets are multiplied by a low number, high risk assets by a higher number.

If a flat 10% risk weight were applied across eurozone banks' EU sovereign exposures, capital requirements would see a "relatively modest" increase of almost €12bn, Fitch said.

However, in another scenario the risk-weight would be based on the credit ratings of the country issuing the debt, from a minimum of 10%, and increasing capital would be required for any sovereign debt above the level of the bank's capital. In that situation banks would have to raise €135bn in capital, Fitch said.

The most likely result would be that banks would gradually sell domestic sovereign debt and move their portfolios towards other securities. The decisions would be made on the cost of carrying capital versus the yield from debt, the impact on profitability and whether the new securities were also affected by EU capital rules, Fitch said.

In practice, this is likely to lead to banks ending up with more government debt from other eurozone countries and less from their own. This could reduce financing flexibility for some governments, and policymakers are likely to act cautiously and make any changes over a long transition period, Fitch said.

Most banks do not currently hold capital against their sovereign exposures or apply large exposure limits on sovereign debt, because this debt has to date been treated preferentially by regulators, the ratings agency said.

Larger banking groups would feel the impact of changes less, as they have more diversified sovereign portfolios, Fitch said.

In the long term, capital requirements on sovereign debt would benefit private sector credit flow by reducing the advantages that sovereign debt holds, it said.  

Banking expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com said capital requirements would "create a significant shift in the perception of sovereign debt as a security. The ramifications across a number of markets would need to be thought through carefully."