Controversial moves are afoot, says the Bank for International Settlements.

The rules governing the treatment of government bonds on bank balance sheets are no longer tenable, says the Bank for International Settlements (BIS) in its annual report.

It reveals that the Basel Committee on Banking Supervision is considering phasing in a capital charge on sovereign bonds. Such a measure is likely to concern many countries, which see banks as an important source of demand for government debt and hence a way to lower their borrowing costs.

The BIS also warns that the current fiscal framework encourages leverage at the expense of financial stability. Examples include government debt guarantees to banks that are underpriced, and tax systems which incentivise debt over equity. Tax breaks typically apply to corporate debt and mortgages in some countries. Making private sector borrowing less attractive, from a tax point of view, would help rein in excessive debt build-ups.   

The BIS also found that implicit government guarantees continue to play a role in supporting global banks, effectively subsidising their lending to the tune of 30 basis points. In the US, around a third of financial sector liabilities enjoy an explicit guarantee and for 26%, it’s implicit.   

Reinforcing the caution over sovereign bonds, the BIS is also calling for countries to take more measures to stop asset bubbles and tackle the causes of financial fragility, such as reviewing tax incentives, which favour debt. This would also help safeguard countries when financial booms go into reverse.

In support of its recommendations, the BIS highlights the median rise in public debt to 15% of economic output in the three years following a crisis. When it came to the 2008 crisis, the situation was far worse. For advanced economies the median increase was 30% of output, and debt levels are now nearly 100%.

Bank bailouts and slower growth often lead to sovereign credit ratings coming under pressure. 

Impact on Europe

Meanwhile, placing capital charges on sovereign bonds, which is also being explored by the European Commission at Germany’s behest as part of a condition for a European deposit guarantee system, could force European banks to raise €171bn in new capital, according to Fitch Ratings.     

European banks are currently sitting on €2300bn of sovereign debt, of which 65% or €1500bn is from the home country. For capital purposes these are usually treated as risk-free, but the euro debt crisis, which threatened sovereign defaults, was seen as a source of contagion and risk for banks.   

EU officials have discussed various possibilities, such as imposing a low-risk minimum weighting in their internal models of 10% for sovereign bond holdings. Other proposals on the table include imposing capital charges linked to the concentration of holdings, effectively to encourage diversification.

This is a move strongly opposed by Italy, where banks are an important holder of sovereign debt. Spanish banks also hold a lot of debt from their home country, although both they and their Italian counterparts have started diversifying their holdings. Indeed, Fitch has fuelled Italy’s concerns by declaring that the move would reduce financing flexibility, particularly for countries on lower credit ratings.  

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