If the rules on risk weightings change, impacting upon the ability and appetite of banks to purchase sovereign bonds, new buyers will be needed.

Eurozone finance ministers are split over the question of banks’ holdings of sovereign bonds. Germany’s finance minister, Wolfgang Schäuble, says that further progress on banking union is conditional on reform of the rules on sovereign debt. Together with the Netherlands, Germany wants sovereign debt to be risk weighted (currently it is zero weighted) and for there to be limits on how much sovereign debt banks can hold.  

Such a shift would be tough for both governments and banks in countries such as Spain and Italy. In Italy, for example, 22% of domestic government debt is held by banks accounting for 10% of total bank assets. 

It is therefore hardly surprising that Italy’s finance minister, Pier Carlo Padoan, is warning that changing the sovereign bond regime could destabilise the financial system. 

He is quoted by Bloomberg as saying: “The most preferable option is the status quo,” as otherwise banks would have to restructure their balance sheets “creating the problem of where this debt will end up. This would provoke a readjustment shock in the market.”

Mr Padoan may be wrong in defending the status quo but he is not wrong in asking who will be the buyers of sovereign debt instead of the banks. Pension funds? Insurance companies? It’s very doubtful as they will have to take due account of the risks. Hedge funds are a more likely buyer, but as we have seen in the case of Argentina this is not always a happy relationship and will make sovereign debt more volatile as it is traded rather than held to maturity. 

Research house Autonomous estimates that if the concentration limit of 25% of bank capital that applies to other asset classes was used for sovereign debt, one-third of eurozone banks would have to sell down their holdings. Autonomous puts the figure of €865bn as the amount of sovereign bonds that would flood the market. 

For sure, governments would only fi​nd new buyers at higher prices, so raising financing costs and adding to the problems of already indebted governments. But doing nothing also carries risks. Zero risk weighting of sovereign debt was created in the days when sovereigns had control over monetary policy and crucially the printing presses – in the eurozone this is no longer case. 

This sets the stage for another battle – between countries that want to keep the status quo, many of which are emerging markets – and those who want to change.

The challenge will be to find a way of gradually reforming the system without causing any shocks along the way. 

Brian Caplen is the editor of The Banker.

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Demetrio Salorio, global head of debt capital markets, Société Générale - View from IMF 2018

The Banker's editor Brian Caplen talks to the global head of debt capital markets at Société Générale, about how some emerging markets are under pressure and what this means for bond issuance.

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