The UK Treasury and Bank of England have undertaken no cost-benefit analysis as part of plans to introduce risk weights on UK bank holdings of EU member state sovereign debt in the event of a no-deal Brexit, according to lawyers briefed on the matter. Regulation experts say this proposal may have less to do with shoring up UK prudential regulation, and more to do with threatening the EU’s sovereign debt issuance in an attempt to force an equivalence deal for the financial sector.
“It seems no-one has done any quantitative analysis on this. We’re all flying quite blind on what both the capital and liquidity implications are for all of this,” says a London-based lawyer who did not want to be named.
The Treasury published a statutory instrument (SI) on August 21 that will amend the EU Capital Requirements Regulation (CRR) after Brexit. The SI states that in the event of no deal, EU government bonds would be categorised as third-country exposures. This means UK banks would have to apply risk weights of between 0% and 150% depending on each sovereign’s credit rating. Spanish and Irish sovereigns would require a 20% capital charge, Italian and Portuguese sovereigns a 50% charge, and Greek bonds a 100% charge.
The lawyer says there was a meeting in August to discuss amendments to the CRR, with staff from the Treasury, Prudential Regulation Authority and Financial Conduct Authority present.
“[They were asked] ‘presumably you’ve done a cost-benefit analysis on what it’s going to mean for the various banks you regulate?’ They all just looked at each other and said ‘no we haven’t’. That comes back to the word irresponsible as far as I’m concerned,” he says.
A second London-based lawyer confirms the UK Treasury has not undertaken any cost-benefit analysis, which he says is a shortcoming also seen with other policy proposals put forward within the scope of Brexit negotiations. “I think if we were both from outside the EU and UK we’d say ‘yes, this looks very odd’,” he says.
Risk Quantum has undertaken a preliminary analysis, which showed HSBC and Barclays would likely face the largest capital hike since they respectively hold £87 billion ($112 billion) and £59 billion of EU sovereign debt under the standardised approach credit risk capital, which allows them to assign a zero risk weight under the CRR.
The UK Treasury and Bank of England did not respond to requests for comment.
Politics over prudence?
Lawyers see the lack of quantitative analysis by the UK Treasury as evidence the proposal is a political threat rather than a carefully informed policy. It contrasts with no-deal planning on other matters, such as the continuity of derivatives contracts and clearing services, for which the Treasury and Bank of England have unilaterally crafted a temporary permissions regime in a bid to protect financial stability. Lawyers characterise the SI on sovereign risk as an act of retaliation rather than prudence.
“I think there is a political angle to this in that the effect of on-shoring EU legislation into UK law is that we inherit the same equivalence mechanism as the EU currently has. So just as they can find us equivalent, we can find them equivalent. One of the effects of that here would be to allow the continuation of this 0% preferential risk weighting of EU sovereign exposures,” says the second London-based lawyer.
A capital manager at a UK bank agrees that the risk weighting question could be a bargaining chip: “There could be a play here. How are your sovereigns going to raise money? We are the biggest market in Europe for raising debt. If you don’t agree, you’ll lose access to that.”
The capital manager says UK banks are likely to cut lower-rated European sovereigns they hold in their banking book if they have previously used the standardised approach. For lower-rated EU government bonds held in the trading book, meanwhile, banks are already required to hold capital against market risk.
“The big chunk is liquidity positions in the banking book. What this [SI] does is encourage you to move out of worst-rated elements of Europe, substantially southern European debt,” he says.
I think there is a political angle to this in that the effect of on-shoring EU legislation into UK law is that we inherit the same equivalence mechanism as the EU currently hasLondon-based lawyer
Some market participants suggest UK banks will simply move their lower-rated EU sovereign bonds to subsidiaries based in the EU. But the capital manager points out that this will still count towards their consolidated capital requirement in the UK, and so will be affected by the rise in risk weights.
He adds that EU subsidiaries hold a significant portion of EU sovereign bonds already, which have been carefully diversified. European Central Bank data for holdings of eurozone sovereign debt by UK monetary financial institutions (MFIs – credit institutions plus money-market funds) shows a figure of just €22.8 billion as at June 2018. This implies the rest of the holdings shown in UK banks’ consolidated Pillar 3 reports are already located in EU subsidiaries that the ECB does not count as UK MFIs.
The capital manager says there would also probably be some effect on the UK gilt market if EU banks were required to impose risk weights on UK government debt, although the effect on the southern European debt market would be more significant: “It would be shooting each other in the foot.”
He says governments within southern and peripheral Europe are likely to put pressure on EU negotiators to ensure the UK is found equivalent, so their ability to raise money is not impaired.
He notes, however, that holdings of sovereign debt by European banks are a highly charged topic. Policy-makers have been fighting since the Greek financial crisis in 2011 to reduce the risk of a ‘doom loop’ that can occur between banks and sovereigns. Furthermore, core sovereigns in Europe such as France and Germany would be much less affected by the introduction of risk weights in the UK, and could even be boosted if UK banks seek to move holdings from the periphery into lower-risk debt.
Primary dealer status
The exact impact of UK banks scaling back their holdings of peripheral eurozone sovereigns is debatable, however. One head of rates strategy at a European bank points out that the stock of government bills and bonds of the 10 largest eurozone members stood at €8.5 trillion as of Q3 2017 by market value, so UK bank holdings are “somewhat minor in the grand scheme of things”.
He adds that UK banks have been reducing their eurozone government bond holdings over the past few years, from a peak in early 2015. This suggests, he says, that UK banks loaded up on holdings ahead of quantitative easing programmes by the European Central Bank, and then sold into the purchase programme thereafter.
What could have a bigger impact is banks withdrawing from acting as primary dealers for the sovereign debt issues of EU governments, says the second lawyer. Many large UK banks compete to manage European sovereign debt issues, for which they need to hold a substantial amount of government bonds from that country in order to make markets.
“So with what’s happening here, it could become more expensive for EU governments to raise money, at least if they use UK banks to run those issues. Of course, the obvious solution is to use banks based in the EU,” he says.
“What I don’t know is whether the EU banks collectively will have the capacity to take on the role UK banks are currently playing in those issuance processes.”
Editing and additional reporting by Philip Alexander