Although the Basel Committee has carefully omitted sovereign risk exposures from its recent consultations on credit risk, it has announced that it is reviewing the risk weighting of sovereign risk exposures. This is also under discussion at various EU fora.
It is not yet known what revisions, if any, will be proposed by the Basel Committee. But they could include:
With €1.6 trillion of sovereign debt held by banks in the EU, higher (than zero) standardized approach risk weights or large exposure limits would have a large impact on the funding costs of banks that would need to raise additional capital; and on the funding costs of some governments. It should however be recognized that to some extent banks may already hold capital against sovereign exposures as a result of stress testing, Pillar 2 capital add-ons, and the leverage ratio.
A recent paper published by the European Stability Mechanism (based largely on data from the EBA’s 2013 transparency exercise) shows that in the euro area:
Under the existing Basel 2 ratings-based approach the sovereign exposures of highly rated countries could remain zero weighted, but elsewhere risk weights would be significant – the ESM paper suggests Greece 150%, Cyprus 100%, Portugal 88%, Spain and Italy 43%. Removing the domestic debt exemption would increase EU-wide capital requirements by €32 billion, including €10 billion for banks in Italy; €7 billion for Spain; €2.6 billion for Portugal; and €2 billion for Greek banks.
A simple example: assume a bank with capital of 10, and risk weighted assets of 100, so an initial capital ratio of 10%. Here is what happens to its capital ratio depending on its holdings of sovereign debt (assume currently zero weighted) and a revised risk weighting:
|Sovereign debt holdings||10||20||30|
|New risk weight|
While German banks would have little problem with the risk weighting of sovereign exposures they would be severely hit by large exposure limits.