Irish banks shed their exposure to domestic sovereign debt

With the same level of domestic sovereign bias, should Maltese banks re-balance their portfolios?

Banking alert | 16 June 2016 | Should Maltese banks re-balance their sovereign title investments?

European regulators are considering enforcing two measures on sovereign debt exposures: apply positive risk weights to address counterparty credit risk and set exposure limits to address concentration risk, while acting as an effort to reduce domestic sovereign bias.

Sovereign bias chart 2015

Portfolio re-balancing in Ireland

According to a report published by ratings agency Fitch, Irish banks are reacting to the potential regulatory developments relating to sovereign exposures by re-balancing their portfolios. In the 18 months to the first half of 2015, Irish banks (AIB, Bank of Ireland and Permanent TSB) cut their exposure to Irish government bonds by 11% and increased their holdings to lower rated sovereign debt from the UK (+1%); Italy (+4%); Spain (+6%) and Belgium (+2%). 

The proposed regulatory measures

The European sovereign debt crisis was magnified by the link between sovereigns and banks. In this regard, European policy makers are discussing how to address the treatment of sovereign debt on bank balance sheets. Currently it is treated as risk free, risk weighted at zero. Additionally, sovereign exposures are exempt from the large exposures framework which imposes a limit of exposures to any counterparty to 25% of own funds.

Regulators are thus considering two measures:

1.    Apply non-zero risk weights; and

2.    Set exposure limits.

While positive risk weights address counterparty credit risk, large exposure limits address concentration risk. Both measures would make banks more resilient, in terms of higher capital buffers and greater diversification, and act as an effort to reduce banks’ exposures to their own sovereigns.

Potential impact of proposed measures in Europe and Malta

According to Fitch, the impact of applying a flat 10 per cent risk-weight across Eurozone banks’ EU sovereign exposures would be a “relatively modest increase” in capital requirements of almost €12 billion to maintain capital ratios. However, an approach designed to penalise excessive concentrations could create requirements of €135 billion.

The proposed measures may also impact sovereign funding conditions. Banks would try to deal with the excess sovereign bonds on their balance sheets by injecting fresh capital or reducing their portfolio of sovereign bonds. This increased supply of sovereign paper, or lack of demand for new issues, would raise funding costs for the sovereign and consequently for the whole economy. 

How we can help

Our experienced team of banking experts can assist you with the following:

  1. Conduct a sensitivity analysis on your investment portfolio to be able to quantify capital premiums that may be required if sovereign risk weight is increased.
  2. Re-balancing exercise of your investment portfolio to better match risk, return and capital requirements.
  3. Produce a capital agenda for the bank including transaction support to divest investments or non-core portfolios, and capital raise planning.
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