Saturday, January 14, 2012

Impact of sovereign downgrades on bank capital

Last night's eurozone downgrade news from Standard and Poors was largely expected. Going forward however these downgrades may impact bank capital requirements for banks who hold sovereign debt. In particular for banks who use the Basle II standard model, the downgrades may increase risk weights for some sovereign bonds. A 100% risk weight means that a $100 holding (for minimum of 8% capital ratio) will require $8 in capital, while a 50% risk weight would require $4 in capital, and so on.
BIS (January 2001): The standardised approach is conceptually the same as the present Accord, but is more risk sensitive. The bank allocates a risk-weight to each of its assets and off-balance-sheet positions and produces a sum of risk-weighted asset values. A risk weight of 100% means that an exposure is included in the calculation of risk weighted assets at its full value, which translates into a capital charge equal to 8% of that value. Similarly, a risk weight of 20% results in a capital charge of 1.6% (i.e. one-fifth of 8%).

Individual risk weights currently depend on the broad category of borrower (i.e. sovereigns, banks or corporates). Under the new Accord, the risk weights are to be refined by reference to a rating provided by an external credit assessment institution (such as a rating agency) that meets strict standards. For example, for corporate lending, the existing Accord provides only one risk weight category of 100% but the new Accord will provide four categories (20%, 50%, 100% and 150%).
Basle II risk weights are determined using ratings - larger banks generate internal ratings while smaller banks tend to apply the "standard model".  Most regulators however expect to see some consistency between rating agency scores and ratings generated by internal models. Under these rules, the risk weights would change as follows:
  1. Spain and Slovenia bond holdings may get adjusted from zero risk weight to 20%. Where in the past no capital was required to hold these bonds, now 1.6% capital charge would be applied. Spanish bonds in particular may have an impact as they are widely held by EU banks (not just eurozone).
  2. Italy bond holdings may get adjusted from 20% risk weight to 50%. This could cause a material increase in capital requirements across the eurozone as well.  Capital charge would increase from 1.6% to 4%.
  3. Cyprus and Portugal bond holdings may get adjusted from 50% risk weight to 100%. This is the biggest capital adjustment (4% to 8%) as the ratings move from "investment grade" to "junk".  Fortunately Portugal's bonds do not constitute a substantial portion of EU bank sovereign bond holdings.
There should be no impact from the France downgrade because those bonds would still have a zero risk weight (as is the case with US treasuries).  Also it is important to note that these capital changes may or may not take place immediately.  Each nation's regulator may have a different interpretation of the rules when dealing with a downgrade by a single agency and not the others. But this move by S&P makes further downgrades by other rating agencies far more impactful because banks applying these capital rules would no longer be able to ignore them.
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