Monday, August 12 15:12:07
EU policymakers paved the way for the region's banks to load up on U.S. municipal debt by creating a loophole that lets them hold minimal capital against the bonds of local authorities like Detroit, which buckled last month under debts of $18.5bn.
EU banks, including bailed-out Belgian lender Dexia , could together face hundreds of millions of euros of losses from the bankruptcy of Detroit.
Dexia alone has set 59 million euros aside to deal with its potential losses, while German banking giant Commerzbank told investors on Aug. 8 that it had taken a "substantial number" as a writedown on its Detroit holdings but declined to say exactly how much.
There is concern that Detroit's filing could eventually create legal precedents that could encourage some cities with a heavy pension and health benefits burden to take a similar route, leaving their lenders nursing losses.
The exposure of Europe's banks to Detroit's debt came as a surprise to some, since unlike U.S. investors, EU banks do not enjoy tax-free income on "muni" bonds issued by U.S. cities, states and other public sector entities.
What they do enjoy, however, is a favourable EU application of global bank capital rules that allows banks to hold only a small amount of capital to cover potential losses on local authority bonds as long as the country in which the municipalities are based has a strong rating.
This means banks can earn high returns from a lowly rated muni bond in a highly rated sovereign without worsening their capital ratios, a neat trick when regulators are demanding higher capital cushions and interest rates are at record lows.
That treatment was first enabled by the Basel II capital rules, which give banks the option of applying either the usual credit-quality-based approach to assigning risk weights to municipal bonds, or a 'standardised' approach that assumes they are only slightly riskier than the debt of its home country.
Capital ratios are calculated as capital divided by risk-weighted assets, so the lower a bank's risk-weighted asset figure, the higher its capital ratio. Hence the standardised model for munis almost always leads to better capital figures than banks' internal models, allowing them to take on more risk elsewhere or flatter their safety profiles.
However, a senior regulator told Reuters the Basel II rules were not intended to be applied in the way they were transposed into European law. The EU package, dubbed CRD III, lets even the biggest banks who use their own internal models to assess the riskiness of the rest of their books - which tend to produce a lower risk weighting for other assets - to use the standardised models to assess the riskiness of their municipal bonds.
The Basel version of the rules allowed this exemption for a transitory period only - the European version permanently enshrined it in law. Several banking sources told Reuters that the low risk weightings were a key factor in their decision to buy muni bonds. Figures from the U.S. Treasury show that non-U.S. investors held $63.7 billion of munis at the end of March.
The senior regulator said banks and European authorities were expected to apply "common sense" and only allow low risk weightings for municipal debt that was actually low risk. He added that banks should considering much more than just the regulatory capital impact when they buy debt - such as whether a bond is a good investment or not.
The suitability of the standardised approach, and its facilitation of the assumption that municipalities carry the same risk as their sovereigns, could be reviewed by the Basel Committee of International Supervisors.
"There was a lot of debate around this when Basel II was being introduced," said Steven Hall, a London-based partner in KPMG's Financial Risk Management practice. "Where you have a regional government that can do its own revenue raising, it can go out and print money, it can raise revenue to pay back its debt.
"So there is a need to be able to differentiate between these kind of institutions and other public sector entities. Whether this is equivalent to central government risk is a further step and will be a matter of regulatory judgment in each jurisdiction."