Banks could be looking at even higher capital requirements if the Basel Committee on Banking Supervision (BCBS) implements new rules that would prevent them from treating all government bonds as risk-free, even though Greece defaulted during the Euro zone sovereign debt crisis and other countries in the EU periphery came close, report Viktoria Dendrinou and David Enrich for The Wall Street Journal. But Rafferty Capital Markets VP of Equity Research Richard X. Bove argues that there’s no way the rules change will happen in the next decade.
Sovereign debt treated as risk-free, despite recent crisis
The rationale behind the change is easy to understand. Basel III compares a bank’s common equity and tier 1 capital to its risk-weighted assets (among other requirements), meaning that a riskless asset doesn’t count against common equity, so banks have an incentive (and the discretion) to consider all government debt to be risk-free even when that’s not necessarily true. Even if a sovereign default in Europe or the US is extremely unlikely at the moment, no one can argue that it’s impossible after living through the last few years.
To address the problem, the BCBS would either force banks to justify its weighting of sovereign debt like it does for any other asset, or simply create a floor that would act as a minimum, non-zero risk for government debt. Either way, banks would immediately see their capital requirements go up.
Countries have a strong interest in having their debt treated as risk-free
The problem, as Bove points out, is that governments would see their borrowing costs go up at the same time. Higher capital requirements are passed on to other borrowers in the form of higher interest rates and there’s no reason to think that governments would be treated differently.
“The Basel Committee’s rules must be approved by the member countries that fund and populate the BCBS Board. The Journal is suggesting that these people are about to put into effect rules that would raise the cost of borrowing to each of the countries on the Board and reduce their access to funding,” Bove writes.
And even if the BCBS can convince heavily indebted countries to vote against their own interests, any proposal will have to weave through negotiations that, according to Bove, could take as much as 17 years to complete. Either way, the prospect of banks having to raise billions in new tier 1 capital to cover sovereign debt in the near future isn’t very likely.