European banks may be forced to sell nearly €500 billion of government debt

Banks across Europe could be forced to sell as much as €500 billion (£391 billion, $569 billion) of sovereign debt, or raise a total of €135 billion in new capital if new regulations about the way sovereign debt is treated in Europe are brought in by the ECB and European Commission, according to a new report from rating agency Fitch.

The potential new rules from the two central bodies essentially concern the way in which Europe's banks rate the riskiness of the government debt they hold. They are being proposed as part of a move to try and eradicate the so-called "doom loop" between lenders and their governments.

The problem was first exposed during the sovereign debt crisis in 2011, and ever since regulators in the eurozone have been scrambling to break that loop. A review into the issue by the Basel Committee for Banking Supervision was launched at the start of 2015, and as Fitch notes: "Proposals to subject EU sovereign exposures to capital requirements and/or large exposure limits were discussed by EU Finance Ministers in April 2016."

European banks currently hold around €2.3 trillion of sovereign debt, 65% of which is from the country where they are based - e.g. Deutsche Bank holding German bunds, or Societe Generale holding French government bonds - Fitch says.

If imposed, new rules will effectively force banks to either shore up their capital holdings to maintain their current solvency levels, or to reallocate or sell sovereign debt. Otherwise, they risk falling foul of regulators and getting slapped with big fines.

Fitch says that in the worst case scenario, banks would either have to reallocate €492 billion of government debt, or raise €135 billion in order to maintain their current solvency levels. The ratings agency does however propose four less drastic scenarios, which it says are probably more likely to occur.

"We believe policymakers will act cautiously, with careful consideration of the impact and with an appropriate time period," Alex Adkins, Fitch's head of credit policy said in a release alongside the report.

The scenarios are as follows:

1. Banks would be made to put in place internal protocols for rating the risk associated with sovereign debt. Fitch's report notes that this would cost the sector around €15 billion in extra capital requirements. Around a third of all big banks in the EU already have such measures in place, and generally rank the risk associated with sovereign debt at less than 5%.
2. Regulators would impose a risk-weighting of at least 10% to sovereign debt holdings. This would result in banks needing €24 billion of extra capital.
3. In this scenario, the amount of risk associated with sovereign debt would be based on the credit ratings of the countries issuing the debt. It would result in a capital requirement increase of €67 billion (£52.3 billion).
4. This scenario combines the second and third options, and would cost €95 billion (£74.2 billion) in new capital requirements.

As with most new regulations in the banking system, it would be the smaller banks in states like Portugal, Spain, and Italy, that would be hardest hit, says Fitch.

"The largest EU banking groups would be less affected by the possible changes because they already use internal model-based approaches to calculate sovereign capital charges and have more diversified sovereign portfolios," it added.

Fitch's report notes that some banks in these smaller states have already started reducing their exposure to the sovereign debt issued by their own governments, something that suggests that they're anticipating regulatory change.

While the regulations have been extensively discussed, there is no definitive time, or even any total certainty of when they will be imposed, or exactly what they will look like.

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