EU backing off 9% Tier I capital target and sovereign debt buffer

As reported in a Bloomberg article, the European bank regulators are taking the first steps to back off of the 9% Tier I capital target and a sovereign debt buffer.

Regular readers know that both the 9% Tier I capital target and the sovereign debt buffer are fundamentally flawed policies.

The 9% Tier I capital target is fundamentally flawed because banks have not yet been required to recognize all the losses hidden both on and off their balance sheets and provide ultra transparency to prove the losses have been recognized.  As a result, market participants are not interested in investing in them as they cannot assess the risk of the banks.

With very limited access to external capital, banks are taking steps to shrink their balance sheet.  These steps include reducing loan origination.  As a result, Europe is facing a credit crunch driven recession.

The sovereign debt buffer is fundamentally flawed because sovereign debt is not risk free.  Banks can lose as a result of both credit and interest rate risk.

Greece is an example of sovereign debt credit risk.

What is not remembered as well is that a large banking holding company in the US demonstrated in the late 1980s that it is possible to lose $250 million for each $1 billion invested in 30 year US Treasury bonds if interest rates increase by 2%.

It is a step in the right direction if the European financial regulators move away from the 9% Tier I capital requirements and the sovereign debt buffer.  It would truly be a step in the right direction if the European financial regulators replaced this flawed policies with the requirement that banks provide ultra transparency.

European bank supervisors may discuss easing requirements for lenders to hold capital against sovereign debt this week as part of more than 30 meetings this month to track banks’ progress in complying with updated requirements, two people with knowledge of the discussions said. 

Regulators will meet this week at the European Banking Authority in London to review capital rules issued in December. National supervisors will probably discuss the so-called sovereign buffer, according to one of the people, a senior EU official who declined to be identified because the talks are private. 

The EBA told banks to raise 114.7 billion euros ($150 billion) in fresh capital by the end of June as part of measures introduced to respond to the sharp fall in the value of securities issued by euro-area governments. 

The EBA required banks to keep a core Tier-1 capital ratio of 9 percent and hold additional reserves, called a sovereign buffer, against the debt of weaker euro-area countries, based upon the market price of the bonds. 

“Calculating the capital needs on the basis of very volatile sovereign yields wasn’t the right thing,” Nicolas Veron, a senior fellow at Bruegel, a Brussels-based economics research group, said in a phone interview. “This is the result of political negotiating and it’s not right to blame the EBA.”

A decision to alter the sovereign buffer would be made in conjunction with the European Systemic Risk Board, a group of European central bankers responsible for monitoring market risk, one of the people said. 

The “need to maintain this buffer, and its size, will be reviewed if and when the policy measures to fight the sovereign- debt crisis have an effect on the price of government bonds,” EBA Chairman Andrea Enria said in a speech in Rome last month....

“This exercise is essential” to help restore confidence in the European banking sector, said Michel Barnier, the European Union’s financial services commissioner. “At the same time, the exercise is being conducted in a way to ensure continued access to finance for the EU real economy.” 

Nobody believes that this exercise will restore any confidence in the financial system.

The only way to restore confidence is to provide ultra transparency and let the market participants independently assess the riskiness of the banks.  Confidence is restored because market participants trust their own analysis.

Banks submitted their plans to raise capital in January and the EBA said in December that lenders aren’t allowed to reduce lending to hit the capital ratios. 

Groups of national regulators that oversee Europe’s largest cross-border banks are scheduled to hold 31 meetings this month to decide whether the banks’ proposals comply with EBA guidelines, one of the people said. 

“The overwhelming majority of measures outlined in the plans appear to be, in aggregate, in line with the spirit and the letter of the EBA’s recommendation,” the agency said in an e-mailed statement today. 

The Financial Times had reported that the EBA would challenge as many as half of the plans.

The regulators face the fundamental problem that there are many ways for banks to reduce lending to the real economy without the headline amount declining.  

For example, banks can lend more to large firms while reducing their exposure to small firms.  By changing the composition of their loan portfolios, banks maintain the facade of continuing to lend while at the same time undermining the real economy.