Tighter Capital Requirements For Investing in EU Government Bonds: Greek Banks Would Incur Problems - But Reform Would Nevertheless Be Desirable

Press Release of May 13, 2015

A tightening of capital requirements for banks that invest in EU government bonds would primarily create a significant additional demand for capital for Greek banks. This is the conclusion of a study conducted by the German Institute for Economic Research (DIW Berlin), which calculated the additional capital requirements such a reform would create for German, French, Swedish, and Greek banks. As of now, financial institutions do not have to use equity capital for investments in EU government bonds, as they do in the case of investments in corporate loans. If this exemption privilege were to be abolished, as was recently proposed by the European Systemic Risk Board (ESRB), it would, according to DIW’s calculations, cost the Greek banks an additional 1.8 billion euros—about nine percent of the existing core capital requirements. In Germany, a reform of the existing regulations would be reflected in the budget with an additional 3.34 billion euros (1.8 percent of the core capital); French banks would need 3.52 billion euros of additional core capital (1.2 percent); and Swedish banks would, in fact, need only 80.6 million euros (0.14 percent). "Especially in light of the European government debt crisis, the privileging of EU government bonds over corporate loans does not make sense,“ said DIW research director Dorothea Schäfer and her co-author, Dominik Meyland. "The taxpayers could also benefit from an abolishment of the EU sovereign bonds’ privilege, as the banks themselves would then provide security against their risks to a greater extent.“ Bank risk and public debt risks would be more strongly decoupled, and the European financial system could be stabilized overall.

German Institute for Economic Research (DIW Berlin)

The German Institute for Economic Research (DIW Berlin) is one of the leading economic research institutions in Germany. Its core mandates are applied economic research and economic policy as well as provision of research infrastructure. As an independent non-profit institution, DIW Berlin is committed to serving the common good. The institute was founded in 1925 as Institut für Konjunkturforschung (Institute for economic cycle research). Since 1982, the Research Infrastructure SOEP (German Socio-Economic Panel Study), a long-term study, is affiliated to DIW Berlin. The institute has been headquartered in Berlin since its founding. As a member of the Leibniz Society, DIW Berlin is predominantly publicly funded.

Greece would have difficulty raising additional capital

If the reform proposal were implemented, the Greek banks would have an increased capital requirement. Measured against GDP, they would have to, at 0.8 percent, raise four times as much new capital as the French financial institutions and in fact six times more than the German banks considered in the study. This is due to the poor credit ratings of Greek government bonds (at the end of 2013, the rating agency assigned them a grade of B-). If the EU sovereign bonds’ capital privilege were abolished, the banks would have to maintain eight percent equity for their holdings of Greek bonds. According to the DIW experts, it would be very difficult in the present situation for Greek banks to raise this capital on the market. "Due to the acute debt crisis, even the government probably couldn’t fill in as an investor,“ said Schäfer.

High expectations for the reform are unjustified

The experts at DIW Berlin warn against excessive expectations for the reform. Although stricter capital requirements can indeed help to improve the ratio of equity capital and total assets, thereby reducing the banks’ so-called balance sheet leverage, this effect will be limited overall, according to the authors’ assessments. Since the risk weight of German, French, and Swedish government bonds stands at zero percent, banks would not have to raise additional equity capital for this purpose, even with a reform of capital requirements for investments in EU-sovereign bonds. Therefore, the equity share of the balance sheet in most of the banks under observation would stand at less than five percent, even after the reform. Furthermore, it is uncertain whether the reform will be implemented at all, as the banks of the European crisis countries in particular would have little incentive to support the reform due to the high additional capital requirements they would incur. Even the heads of state and chief executives of these countries are likely to be skeptical of a revision, since it would make their government bonds significantly less attractive to investors.