Why Smaller Banks Pay the Price for Europe’s Doom Loop

Government bond holdings are a bigger part of smaller banks’ balance sheets

By Paul J. Davies

Europe is getting closer to breaking the doom-loop between banks and their national governments. For Italy and Spain, this could prove costly.

The problem is that many European banks still treat bonds from their own governments as if they were entirely risk free: that means they hold no capital against them. This makes such debt attractive to own, even at very low prevailing interest rates, and helps keep borrowing costs at a bare minimum.

Forcing banks to hold capital against sovereign-bond exposures would mean they need to increase their total capital by between 2% and 25% under five different and progressively harsher scenarios calculated by Fitch Ratings. The most painful of these would entail a need for $170 billion in extra tier-one and tier-two capital across European banks. That would be unless they sold large chunks of their domestic sovereign bonds.

And while that sounds like a lot, consider that the requirement will fall disproportionately on smaller banks.

The biggest banks in Europe all tend to hold capital against government bonds already, plus they hold bonds from more governments. Fitch reckons none of Europe’s 12 globally systemically important banks breaches rules that say banks’ exposures to a single borrower shouldn’t exceed 25% of its capital base. Nordea NRBAY -0.90 % has the greatest exposure at about 20%.

For many smaller banks, the levels are much higher: domestic government bond holdings are on average equivalent to more than 175% of capital for all banks in Belgium, Germany, Italy and Spain.

European regulators already see Italian banks as needing more capital, while the government is trying to force consolidation to take out excess capacity and help the industry tackle its bad-loan mountain. Some of those are struggling to raise equity as it is.

When it comes to putting up capital against domestic bonds, they looked damned if they do, doom-looped if they don’t.

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