Jens Weidmann, president of the Bundesbank, has risked angering Europe’s crisis-hit governments by warning of the dangers posed by high levels of sovereign debt on banks’ balance sheets.
Writing in the Financial Times, Mr Weidmann demands that lenders cut their holdings of government bonds and set aside more capital to reflect their riskiness. “The time is ripe to address the regulatory treatment of sovereign exposures,” he writes.
His intervention comes as the European Central Bank considers whether to offer another set of cheap multi-year loans, known as long term refinancing operations or LTROs, as its first two LTROs, deployed in 2011 and 2012, approach maturity. Anecdotal evidence suggests a great part of the €1tn the ECB pumped into the banking system in LTROs was invested in sovereign debt.
Mr Weidmann notes that there is no limit on a bank’s exposure to a single sovereign, whereas the risk they can take on from other counterparties is limited to a quarter of their eligible capital. Additionally, sovereign debt attracts low or zero capital requirements for the banks.
This has made it very attractive for banks to invest in government bonds and the “home bias” of buying the local sovereign’s debt has increased during the crisis. Because such debt can usually be lodged as collateral at the ECB in return for cheap funding, exposure to government bonds of countries like Spain and Italy is even more attractive since the debt now also yields more.
“The more vulnerable banks are, the more they expose themselves to sovereign debt,” Mr Weidmann writes. “Weak banks invest in high-yield sovereign bonds and refinance at currently low interest rates. Such ‘carry trades’ sustain the low profitability of those banks and postpone necessary adjustments of their business model.”
The Bundesbank chief, who also sits on the ECB’s governing council and stood alone in opposing its landmark bond-buying plan last year, said the banks loading up on such debt enjoyed the “yield mark-up if things go well” and “what happens in the event of a joint sovereign-bank default is not relevant to them.”
Across the euro area, the share of sovereign bonds in total bank assets has increased over the past five years to 5.3 per cent from 4 per cent. But the figure rises to 10 per cent for banks in Italy and 9 per cent in Spain, according to calculations by Barclays.
While Mr Weidmann’s proposal would entail big changes in regulation and would take years to agree, it could weigh on ECB policy makers’ minds as they consider another LTRO and prepare to undertake a comprehensive assessment of the health of the biggest 130 eurozone banks ahead of taking over supervisory responsibility for them in a year’s time.
Additional reporting by Ralph Atkins in London