New rule change could fuel bank-sovereign ‘doom loop’ - World -
debt loop

Rise in carry trades could reinforce trend that contributed to European sovereign debt crisis, warns Fitch.

EU banks could increase carry trades in response to new rules insulating them from reporting fair value on the back of movements in their sovereign bond holdings, according to a report from Fitch Ratings.

The rating agency warned the change could reinforce the sovereign-bank nexus that contributed to the last European sovereign debt crisis.

Carry trades involve borrowing at low interest rates to invest in higher yielding assets – a trading strategy typically associated with currencies.

The rating agency said the European Central Bank (ECB) targeted longer-term refinancing operations (TLTRO III) is enabling commercial banks to do carry trades by borrowing from the central bank at negative interest rates to invest in higher yielding sovereign debt.

This trade is further incentivised by the ECB reducing the interest rate for TLTRO III loans to -0.5% from June 2020 to June 2021 to as low as -1% if banks meet private-sector lending thresholds.

TLTRO tightrope

The ECB’s TLTRO has been a significant source of profitability for eurozone banks in recent years, many of which are struggling with tight margins due to very low interest rates.

Also, they can now do this trade without the risk of capital depletion should interest rates rise or wider spreads reduce the fair value of those holdings.

The rating agency added that EU supervisors gave banks more capital headroom by allowing them to neutralise the capital impact of stage 1 and stage 2 expected credit losses incurred in 2020 and 2021 and by reintroducing a ‘prudential filter’ to insulate capital ratios from fair-value movements in sovereign bond portfolios. Full insulation applies during 2020, reducing to 70% in 2021 and 40% in 2022.

The rating agency warned the change could reinforce the sovereign-bank nexus that contributed to the last European sovereign debt crisis.

Due to a combination of relaxing fair value rules and the ECB’s TLTRO, Fitch Ratings wrote that it expects the amount of sovereign debt held by EU banks to increase significantly this year from the €3,000bn gross carrying value held at end-2019.

The rating agency noted that this type of carry trade is generally not a problem if the sovereign bonds in question are sound. But it warns that should a sovereign or its banking sector come under financial stress, powerful adverse feedback loops can transmit risks between the two, potentially threatening financial system stability, as happened during the 2009-2012 eurozone sovereign crisis.

This article first appeared in The Banker's sister publication Global Risk Regulator

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