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The European debt crisis may force banking regulators to diminish the central role of government bonds in planned rules designed to make the financial system safer. As they fine-tune the new regulations, scheduled to take effect starting in 2013, the officials face a balancing act between acknowledging investors’ loss of confidence in sovereign debt and the need to avoid undermining governments’ credibility.
The Basel Committee on Banking Supervision, which coordinates regulations for 27 nations around the world, approved preliminary guidelines, known as Basel III, in 2010. The rules govern, among other things, how much cash and other liquid assets banks must have on hand to withstand short-term funding crises. Basel III’s so-called liquidity coverage ratio calls for banks to hold enough “high-quality liquid assets”—mainly cash and government debt—to survive 30 days of stress.
Thanks to the European debt crisis, it’s now apparent that not all government IOUs should be considered high quality. On Dec. 5, Standard & Poor’s said it may strip Germany and France of their AAA credit ratings* and that it was putting 15 euro-area nations on review for possible downgrade. That comes after some holders of Greek debt have agreed to a 50 percent reduction in the value of their bonds. “One of the central pillars of the Basel III framework is the notion of a risk-free asset class,” says Matthew Czepliewicz, a banking analyst at Collins Stewart Hawkpoint in London. “That central pillar is disintegrating.”
Now the Basel committee may allow banks to use stock investments and more corporate debt—plus cash and government bonds—to meet liquidity requirements, according to two people with knowledge of the plans who requested anonymity because the talks are private. “In a world where Nestlé is seen as less risky than Portugal, it makes complete sense,” says Bob Penn, partner at law firm Allen & Overy in London. The problem is that such a move would make it harder for governments to raise money, he says: “The state requires someone to Hoover up its own debt. Discouraging banks from investing in some countries’ bonds could have a damaging effect on sovereign borrowing.”
The deterioration of European sovereign debt is also leading some regulators to question Basel rules that say banks don’t need to hold any capital against potential losses on government bonds. Regulators should distinguish between the sovereign debt of countries that have control over their own monetary policy and “subsidiary” sovereign bonds issued by countries in the euro zone, Adair Turner, chairman of the U.K.’s Financial Services Authority, said in a Nov. 21 speech at the Center for Financial Studies in Frankfurt.
As the European crisis drags on, even governments once considered safe are struggling to attract investors. Germany was unable to sell about 35 percent of the €6 billion of 10-year bonds it offered on Nov. 23. Meanwhile, the turmoil in Europe has boosted demand for government bonds of countries outside the euro zone, pushing yields lower. Ten-year U.S. Treasuries yielded about 2.1 percent on Dec. 6 compared with 3.29 percent at the start of the year. Yields on Swiss government bonds of a similar maturity have tumbled to about 0.8 percent from 1.64 percent. “Day by day, there seem to be fewer asset classes that the market regards as risk-free, such as U.S. Treasuries and Swiss government bonds,” says Czepliewicz. “And the banks can’t all load up on U.S. debt.”
(* S&P’s AAA-rated countries: Australia, Austria, Canada, Denmark, Finland, France, Germany, Hong Kong, Liechtenstein, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, U.K.)
The bottom line: With investors taking losses of 50 percent on Greek bonds, regulators are rethinking the role of sovereign debt in bank liquidity rules.