ECB Admits Sovereign Bonds Are Not Riskless

Tyler Durden's picture

For the last year or two, European banks have engaged in the ultimate of self-referential M.A.D. trades - buying the sovereign debt of their own nation in inordinate size to maintain the ECB's illusion of control (even as their economies collapse and stagnate) while referentially obtaining the funding for said purchase from the ECB by repoing the purchase back to the central bank, usually with no haircut to mention. Today though, as The FT reports, a top official at the European Central Bank has signalled it will try to force eurozone banks to hold capital against sovereign bonds, in an attempt to stop weak lenders using its cash to hoover up the debts of crisis-hit countries.

This is a problem as banks assume zero risk-weights (under BIS III) to these "assets" as they swap them for cash with the ECB and, as Praet notes, if sovereign bonds were treated “according to the risk that they pose to banks’ capital” during the health check, then lenders would be less likely to use central bank liquidity to buy yet more government debt.

Via The FT,

A top official at the European Central Bank has signalled it will try to force eurozone banks to hold capital against sovereign bonds, in an attempt to stop weak lenders using its cash to hoover up the debts of crisis-hit countries.

 

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the central bank could combine its new powers as chief banking regulator with its existing role as currency issuer to toughen up the requirements on sovereign bonds, which have been traditionally classed as risk-free.

 

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Mr Praet said if sovereign bonds were treated “according to the risk that they pose to banks’ capital” during the health check, then lenders would be less likely to use central bank liquidity to buy yet more government debt.

 

The vicious cycle that has seen banks use central bank cash to buy government bonds has been partly blamed for prolonging the eurozone financial crisis.

But do not worry - should this decision to force banks to hold more capital against their massive sovereign bond books backfire (though credit creation is already dismal), the ECB will save the day...

If the health check were to choke off lending to eurozone households and businesses then the ECB would provide another round of cheap loans, Mr Praet said.

 

He said monetary policy would be used “without hesitation” if the ECB’s data on money and credit showed banks were continuing to shrink their loan books. The ECB would ensure any liquidity was used to spur lending to the real economy by attaching tougher requirements to banks’ holdings of sovereign debt.

And ever the optimist,

“Perhaps paradoxically, a rigorous AQR and stress test helps monetary policy [function],” Mr Praet said.

but the kicker is...

Should the procyclical impact of the AQR be significant, then monetary policy would be able to act – without hesitation and being reassured that the side effects of a liquidity injection that we have seen for the 2011-2012 [three-year long term refinancing operations] would be minimised.”

Though it appears to us that the "side effects" of massive liquidity-driven demand for the bonds of the distressed nations smashing their risk to record lows while the economies of those nations languishes - is exactly what they wanted...

So again - it comes back to their reliance on the ECB's "we'll collateralize any-old-shit at Par" programs, its unintended consequence of driving the banks and the sovereigns even more symbiotically intertwined, and its inept belief that the stress tests to be undertaken next year will solve all the problems...

And Italy may be screwed...

Wondering why the Italian bond market has been stable and "improving" in recent months, with yields relentlessly dropping as a mysterious bidder keeps waving it all in despite the complete political void in the government and what may be months of uncertainty for the country, and despite both PIMCO and BlackRock recently announcing they are taking a pass on the blue light special offered by BTPs? Simple. As the Bank of Italy reported earlier today, total holdings of Italian bonds by Italian banks hit an all time record of €351.6 billion in February.

 

 

Why are local banks loaded to the gills in the very security that may and will blow up their balance sheets when the ECB loses control of the European sovereign risk scene as it tends to do every year? Because courtesy of ECB generosity, Italian debt continues to be "cash good collateral" with the ECB, and as a result Italian banks can't wait to pledge and repo it with Mario Draghi in exchange for virtually full cash allottment.

In other words, the more debt the Italian Tesoro issues, the more fungible cash the Italian banks have to spend on such things as padding up their cap ratios and making their balance sheets appear like medieval (any refernce to Feudal Europe is purely accidental) fortresses.

Until - the ECB changes the rules...