A Bank of Italy paper illustrates and explains the rise in European banks’ sovereign debt holding since the great financial crisis. It also reiterates structural causes for bank-sovereign feedback loops. One would conclude that this nexus remains an important factor for market dynamics and monetary policy.
Hagendorff and Vallascas argue that the risk weights used to calculate banks’ capital adequacy fall significantly short of true portfolio risks. Capital arbitrage may have undermined Basel II capital regulation and could do the same for Basel III in the future.
From 2015 banks will have to satisfy new liquidity standards. Of particular importance is the liquidity coverage ratio, which requires institutions to hold enough “high quality liquid assets” to withstand a 30-day period of funding stress. This will complicate the conduct of monetary policy and affect short-term yield curves, which will probably price some regulatory term premium.
Standard & Poor’s research suggests that Japanese banks’ government bond holdings and interest rate risks of have almost doubled over the past 10 years. Against the backdrop of more aggressive reflation policies (view here) this translates into a systemic risk. An increase in long-term yields by 200bps compared to 2012 could already impair the banking system. An increase by 300bps or more could spell broadly based challenges for capital adequacy. A concurrent drop in equity would increase the pressure.
A new IMF Staff Discussion Note provides opinion and advice on the euro area banking union. It reiterates the urgent need for a single regulatory, resolution, and deposit insurance mechanism. The present legal and institutional reality falls well short of it and even last year’s adopted directives and plans only deal with the harmonization of rules and the creation of a single supervisory mechanism (SSM). A credible euro area-wide resolution and deposit insurance seems to be still a distant goal. The ESM’s ability to bear recapitalization losses, whether from “legacy assets” or not, remains uncertain.
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