As arbitrage opportunities go, the zero-risk-weight treatment of sovereign debt under the Basel regulatory framework is a pretty big one. Banks can hold such instruments and reap their returns without ever having to put a penny of capital against them. Sovereigns also benefit through lower borrowing costs, as demand is naturally higher for such lucrative assets.
This happy arrangement could soon come to an end, however. Both the Basel Committee and the European Central Bank have announced that the approach should change. As the eurozone debt crisis continues to play out in all its slow-motion, gory detail, regulators can no longer avoid the fact that sovereign defaults are not just a theoretical possibility. Banks across Europe hold many millions of euros' worth of debt issued by vulnerable peripheral nations, presenting a systemic threat to the financial system.
Ending the sovereign risk subsidy will not be easy. Academic research suggests that, as of June 2013, it allowed European banks to reduce their risk-weighted assets by €750bn. The actual amount of capital banks may need to assign to individual sovereign bonds if risk weights are introduced is not enormous – €2m for €100m of German debt, for instance. But the cumulative effect will be significant. Banks in Europe alone would face a collective capital shortfall of at least €90bn. The effect on emerging market banks, which buy and hold government debt as a major plank of their business model, could be even more punishing.
Regulators recognise that if sovereign risk weights are introduced in one fell swoop, it could dislocate the primary and secondary markets for such debt. An alternative would be to impose a risk limit on own-country debt held by banks. This approach has its challenges too, but regulators need to find a solution at some point. The perversity of the current situation becomes ever clearer as problems in Greece and elsewhere rumble on.
