Sovereign debt rule change ‘could prompt €1.1tn rebalancing’

More than a trillion euros of government bonds may have to change hands if eurozone regulators press ahead with ambitions to toughen rules governing banks’ sovereign debt holdings, new analysis shows.

A limit on banks’ exposure to their own government’s debt could prompt a €1.1tn rebalancing of euro area sovereign debt portfolios, mostly away from banks’ home governments, according a report from Fitch Ratings.

The biggest impact would be felt in the German government debt markets, as banks were forced to shed €330bn of Bunds.

The next biggest overhaul would be in Italian debt, where €243bn of sovereign bonds would have to change hands, and then Spain, where the figure would be €206bn. In Greece €16bn-worth of government bonds would have to change hands.

As a share of government debt, the largest rebalancing would be in Spain, where bonds worth more than 20 per cent of general government gross debt would have to be put up for sale. Germany, the Netherlands and Belgium would all have to see a rebalancing of more than 10 per cent of gross government debt.

The overall impact would be offset to the extent that rival banks snapped up bonds that euro area lenders were forced to sell.

Danièle Nouy, the head of the euro area’s new Single Supervisory Mechanism, has repeatedly expressed concerns about banks’ heavy holdings of bonds issued by their own governments.

The region wants to break the so-called doom loop between banks and their sovereigns, in which a deterioration in a government’s bond market undermines the health of its financial system – something that was seen at the heights of the euro crisis.

As things stand, most sovereign debt holdings are exempt from “large exposures” limits applied to banks’ lending to companies and individuals, allowing banks to accumulate huge portfolios of their own country’s sovereign debt.

“Medium-sized Italian and Spanish banks have a particularly strong home bias,” Fitch said, “with the median bank in both countries having nearly all of their sovereign exposure to their home sovereign.”

The ECB has not set out specific plans to tackle the issue. But the Fitch report shows that if regulators were to adopt a Basel rule that caps banks’ exposure to a single counterparty at 25 per cent of total capital resources, it would trigger a large overhaul.

The scale of the overall portfolio rebalancing would be even larger, €1.34tn across the region, if the large exposure limit were set at 10 per cent, an idea some euro area officials have mooted.

It is not clear if banks would respond by shifting into bonds issued by other euro area governments, or by reducing their sovereign holdings and moving into other assets. Any change in the rules would probably be implemented only very gradually.

Ms Nouy told the Financial Times in February: “Sovereigns are not risk-free assets. That has been demonstrated, so now we have to react. What I would admit is that maybe it’s not the best moment in the middle of the crisis to change the rules.”

She suggested the idea of “some kind of large exposures limits so you don’t put all your eggs in the same basket”.