ECB not likely to unilaterally impose risk weighting on sovereign bonds, but haircuts possible in stress tests:
The ECB President (Mario Draghi) poured cold water yesterday on the prospect of European regulators moving unilaterally to assign risk weightings to governments bonds. Mr Draghi indicated that such measures would first need to be agreed and discussed with the Basel Committee of global regulators “at the proper time”. However he advised that the ECB still intends to scrutinise sovereign bond holdings as part of its Comprehensive Assessment next year.
We think that an aggressive stress test scenario incorporating material sovereign haircuts is likely to have a proportionally greater adverse affect on weaker peripheral banks, given their elevated holdings of relatively lower credit rated domestic bonds compared to stronger banks in core Member States. In this regard, the finer details of the stress parameters and methodology (hopefully published in January) will be key to determine whether the banks take action to reduce sovereign concentration over coming months. Though we note that many European institutions purchased sovereign bonds at distressed levels over the crises, with significant unrealised gains when currently marked-to-market due to improved pricing.
We mentioned yesterday that the PCAR Irish banks had €20.6bn of domestic government bonds (AIB – €9.6bn, BoI – €5.9bn, ptsb – €5.1bn) at June 2013. While we note that the spectre of stringent capital treatment to sovereign exposures appears to have abated for the time being, we estimate that the PCAR institutions would have to risk weight their Irish debt holdings at 50% based on the current Irish sovereign credit rating (Ba1/BBB+/BBB+). This is based on application of the standardised approach under the Basel capital framework and would have the effect of reducing the PCAR banks’ aggregate 2013 year-end CT1 capital by €1.3bn and lower CT1 ratios by c. 100bps (AIB), 70bps (BoI) and 200bps (ptsb). While we expect this topic to be on regulators’ agenda over coming periods, a possible compromise in our view may involve national authorities applying risk weighting only to future acquisitions of sovereign debt holdings, giving the sector time to reposition balance sheets without placing undue pressure on capital levels or sovereign bond markets. Though these measures may still reduce banks’ appetite to support new sovereign funding issuances and diminish the domestic bid at the time of future auctions.
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