A possible move by regulators to push EU banks into shedding substantial exposures to their respective sovereigns could increase demand for covered bonds, according to S&P and Fitch, with banks likely to switch into the asset class because of its preferential treatment under LCR.

In a meeting of the EU’s Economic & Financial Affairs Council (Ecofin) on 22 April, finance ministers discussed ways in which regulators could break the so-called “sovereign-bank nexus” or “doom loop”, whereby banks’ credit quality is tied to their domestic sovereign – something deemed a key contributory factor in the financial crisis.

Ministers discussed five possible policy options, which all including either changes to the current zero risk-weights for sovereign exposures or the introduction of maximum exposure limits.

In a report published on Tuesday, Standard & Poor’s said that in its view “the calls for a rethink are understandable”, noting that the sovereign debt crisis, and Greece’s restructuring of its debt in 2012, had highlighted the dangers of banks carrying significant sovereign exposure.

However, the rating agency noted that EU banks’ sovereign exposures have grown in recent years, citing a list of reasons that banks hold large shares of the securities – their preferential regulatory treatment, their favourable credit and liquidity characteristics, use as a collateral instrument, and to meet Basel’s Liquidity Coverage Ratio (LCR).

While emphasising that it believes meaningful reform is currently out of the question because of disagreements among EU members, S&P said that the introduction of risk-weights greater than zero under Pillar 1 would be the less disruptive option.

The rating agency estimated that if banks’ general government exposures were instead limited to 25% of their own funds – the same limit currently applied to a bank’s exposure to a single client or group of connected counterparties – then the largest 50 banks in Europe would consequently have to rebalance up to Eu1.7tn of EU exposures.

One impact of such a rebalancing, the rating agency said, would be to increase demand for covered bonds, as the asset class also enjoys beneficial treatment under the LCR.

“When it comes to meeting the LCR, the most likely non-sovereign alternative exposures would be covered bonds, with approximately Eu1.8tn outstanding in Eurozone countries,” said the S&P analysts.

In a similar report published on 8 June, Fitch also said that non-zero risk-weights for sovereign exposures could increase appetite for other debt instruments with low capital charges, including covered bonds.

“Any imposition of hard or, more likely, soft sovereign concentration risk limits could boost the appeal of covered bonds as an alternative to holding sovereign debt,” said Fitch analysts.

Photo: Eurogroup president Jeroen Dijsselbloem; Source: European Union 2016 – European Parliament