The treatment of sovereign debt and risk under the new regulatory framework

1. New Financial Regulations,
Implementation of Basel III,
and Debt Management:
Conceptual Issues
Cristina Pailhé
IFD/CMF Consultant
10th Annual Meeting LAC Debt Group
Asunción, Paraguay
11-13 August 2014

2. Background
• The international financial crisis motivated a significant set of reforms:
1
•To correct the weaknesses that led to the global crisis
2
•To build safer, more resilient sources of finance to serve better the
needs of the real economy
•These reforms have direct and indirect, intended and/or unintended consequences on
sovereign risk and sovereign debt management, pricing and demand.

3. • Complacent pricing and accumulation of sovereign risk up to 2009 by banks. Market led
phenomenon (H. Hannon, BIS, 2013)
• Banks engage in ‘carry-trade’ investment strategies incentivized by the current treatment
in capital requirements
• Regulation provide incentives for banks to accumulate too large sovereign exposures.
• ‘financial repression’
• captive investor base
• Highly rated sovereigns are low-risk but they are no longer perceived as risk-free
• Since the bank bailouts, sovereign and banking default risks as closely intertwined
Background
Are these risk recognized and captured by current capital/regulatory
requirements?
What are the implications for sovereign debt markets?

4. Some of the regulations affecting sovereign debt markets
• Basel II, Basel II.5 and Basel III:
• Capital requirements
• Leverage ratio
• Liquidity ratios: liquidity coverage ratio (LCR) and net stable funding ratio (NSFR)
• Regulations encouraging OTC derivatives to be moved towards central
counterparties (CCPs) and trading platforms.
• The implementation the Dodd-Frank Act in the US, and Capital
Requirement Directive IV in the EU

5. Basel III
• Comprehensive set of prudential rules developed by the BCBS after the
financial crisis.
• It raises the resilience of the banking sector by strengthening the regulatory
capital framework, building on the three pillars of the Basel II framework.
• A new definition of capital
• Capital buffers
• Liquidity ratios
• A leverage ratio
• An enhancing of risk coverage
Basel III includes
• Published in December 2010, and progressively completed and complemented.

6. Basel II: capital requirements
• Basel II is still the standard to calculate minimum regulatory capital. Is has not
changed under Basel III.
For credit risk:
Standardized Approach (SA). Reliant on ratings from Credit Rating Agencies
Internal Ratings-Based (IRB) approach – (Foundational or Advanced). Based
on banks’ internal credit ratings
• Pillar 1 requirements are complemented with supervisory review (Pillar
2) and banks’ disclosures requirements (Pillar 3).
Pillar 1: establishes the minimum regulatory capital to cover credit, operational and market risks

7. Basel II: Standardized Approach for credit risk
• Under the SA sovereign exposures in the banking book are risk weighted
according to their external rating.
Credit
assessment
AAA to AA- A+ to A– BBB+ to
BBB–
BB+ to B– Below B– Unrated
Risk weight 0% 20% 50% 100% 150% 100%
Capital
requirement
0% 1.6% 4% 8% 12% 8%
• National discretion: lower risk weight (eventually 0%) to banks’ exposures to their
sovereign (or central bank) of incorporation denominated in domestic currency and funded
in that currency.
• The case of the EU and several LATAM countries

8. Basel II: Internal Ratings-Based Approach for Credit Risk
Sovereigns
Illustrative IRB capital charge for sovereigns (%)
Probability of default Risk weight Capital charge
0.01 7.53 0.60
0.02 11.32 0.91
0.05 19.65 1.57
0.10 29.65 2.37
0.25 49.47 3.96
0.50 69.61 5.57
0.75 82.78 6.62
1.00 92.32 7.39
2.00 114.86 9.19
3.00 128.44 10.28
4.00 139.58 11.17
5.00 149.86 11.99
6.00 159.61 12.77
10.00 193.09 15.45
20.00 238.23 19.06
• Using a Basel formula,
inputs (PDs, LGDs, M) are
converted into risk weights
and regulatory capital
requirements.
• Treating a significant portion
of sovereign exposure as
risk-free contradicts the
granularity required for a
meaningful differentiation of
risk.
• There is no floor for the PD
as for corporate and bank
exposures (3-basis points)
Assumes LGD of 45% and maturity (M) 2.5 years.
Source: BCBC and H. Hannoun (2013)

9. Basel II: IRB risk weights for sovereigns
• IRB can produce some risk differentiation by assessing individual
sovereign exposures and getting more granular estimates
• Very low capital charges for advanced economies sovereign portfolios =>
differentiation quite immaterial in practice.
• Very low default frequency observed in advanced economies and limitations in the
risk-weighting mechanism.
=> Some IRB estimates are not so different from the SA in practice.
• Tend to rely on external ratings as a reference point.

10. Basel II.5: capital charge in the trading book
• Introduces an Incremental Risk Charge (IRC):
• capture losses due to both default and credit rating migrations for all trading positions,
including government exposures.
• banks need to measure and hold capital against both risks, that are incremental to the specific
risk captured in VaR models.
• it was incorporated in response to the increasing amount of exposure in banks’ trading books to
credit-risk related products whose risk was not properly reflected in VaR.
• Limit incentives to hold assets in the trading book vs. the banking book
• Higher capital charges for securitized assets in the trading book

11. Basel II: Pillar II and sovereign risk
• Risks not fully captured by Pillar I might be addressed by Pillar II.
• Supervisors could consider specific measures, e.g. when credit and concentration
risk are deteriorating and exceeding manageable levels:
• interaction with the bank; e.g. dialogue with senior management
• most intrusive or preventive actions; eg. adjustment of valuations
• applying a specific provisioning policy to the assets
• requiring to strengthen its capital base.

12. Basel III: Leverage ratio
• Banks should hold a minimum of eligible capital of their stock of non-risk-
weighted assets.
• Reporting to national supervisors as from 1 January 2013. Public disclosure starting 1 January
2015. Final calibration completed by 2017. Migration to a Pillar 1 treatment on 1 January 2018.
LR
Objectives:
Constrain the build-up of leverage in the banking sector
Reinforce the risk based requirements with a simple, non-risk based “backstop” measure
Helping avoid destabilizing deleveraging processes which can damage the financial
system and the economy

13. • Leverage Ratio =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑀𝑒𝑎𝑠𝑢𝑟𝑒
𝐸𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑀𝑒𝑎𝑠𝑢𝑟𝑒
≥ 3%
Basel III: Leverage ratio
Capital Measure: Tier I capital
Exposure measure:
on-balance sheet exposures;
derivative exposures;
securities financing transaction (SFT);
off-balance sheet (OBS) items.

14. Basel III: Leverage ratio and sovereigns
• Sovereign debt fully included in the exposure measure.
• The LR has the potential to act as a quantity-based constraint to the amount of
sovereign debt banks hold.
• It is a disincentive for banks holding low-yield sovereign debt
• It is a significant constraint for banks with important trading operations.
• The LR is a disincentive for banks to engage in activities that are low-
margin and balance sheet intensive => impact on sovereign repo.

15. Basel III: Liquidity requirements
Liquidity Coverage Ratio (LCR)
LCR =
𝑆𝑡𝑜𝑐𝑘 𝑜𝑓 ℎ𝑖𝑔ℎ 𝑞𝑢𝑎𝑙𝑖𝑡𝑦 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑳𝒆𝒗𝒆𝒍 𝟏+𝑳𝒆𝒗𝒆𝒍 𝟐)
𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑛𝑒𝑥𝑡 30 𝑐𝑎𝑙𝑒𝑛𝑑𝑎𝑟 𝑑𝑎𝑦𝑠
≥ 100%
Level 1
Cash, coins, central bank reserves, high rated securities issued or guaranteed by the
sovereign or central bank (in domestic currency if sovereign has non 0% risk weight,
otherwise subject to limits). No limits.
Level 2
Securities issued or guaranteed by sovereigns, central banks, PSEs or multilateral
development banks with 20% risk weight; corporate debt securities and covered
bonds; residential mortgage backed securities; common equity shares. All must meet
specified conditions. Limited to 40% of the overall stock of liquid assets.
The LCR will be introduced on 1 January 2015. The minimum requirement will be set at 60% and rise in equal
annual steps to reach 100% on 1 January 2019.

16. • No limits on HQLA means the whole buffer could consist of government bonds
• Safe assets are hoarded
• Sovereign rated below AA- threshold are still eligible as Level 1.
• Highly rated corporate and covered bonds qualify as Level 2, albeit subject to limits.
• The BCBS quantitative impact study found that banks currently hold Level 2 assets
amounting to well below 40% of their total liquid assets.
• Banks can diversify their liquidity buffers globally
• These are higher-yielding assets
Banks will demand more sovereign assets
Basel III: LCR
Effects on sovereign assets
Demand from other (liquid) assets will also increase
• No limits on HQLA means the whole buffer could consist of government bonds
• Safe assets are hoarded
• Sovereign rated below AA- threshold are still eligible as Level 1.
• Highly rated corporate and covered bonds qualify as Level 2, albeit subject to limits.
• The BCBS quantitative impact study found that banks currently hold Level 2 assets
amounting to well below 40% of their total liquid assets.
• Banks can diversify their liquidity buffers globally
• These are higher-yielding assets
Banks will demand more sovereign assets
Demand from other (liquid) assets will also increase

17. • Banks have to maintain a stable funding profile in relation to the composition of
their assets and off-balance sheet activities.
NSFR =
𝐴𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 (𝐴𝑆𝐹)
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑖𝑛𝑔 (𝑅𝑆𝐹)
≥ 100%
Basel III: Liquidity requirements
Net Stable Funding Ratio (NSFR)
ASF
The portion of capital and liabilities expected to be reliable over the time horizon
considered by the NSFR (one year).
RSF
It is a function of the liquidity characteristics and residual maturities of the assets
and off-balance sheet (OBS) exposures held by the institution.
• The NSFR is not fully completed yet. NSFR, including any revisions, will become a minimum
standard by 1 January 2018.

18. NSFR: Capital and liability categories and associated ASF factors
ASF factor Components of ASF category
100%
• Total regulatory capital
• Other capital instruments and liabilities with effective residual maturity ≥ 1 year
95% • Demand and term deposits with residual maturity ≤1 year, from retail and SME customers
90%
• Less stable non-maturity deposits and term deposits maturity <1, from retail and SME
customers
50%
• Funding with residual maturity <1 provided by non-financial corporate customers
• Operational deposits
• Funding with residual maturity <1 year from sovereigns, public sector entities (PSEs), and
multilateral and national development banks
• Other funding with residual maturity ≥6 months and < 1 year not included in the above
categories, including funding provided by central banks and financial institutions
0%
• All other liabilities and equity not included in above categories, including liabilities
without a stated maturity
• Derivatives payable net of derivatives receivable if payables are greater than receivables

19. NSFR: Asset categories and associated RSF factors
RSF factor Components of RSF category
0%
• Coins and banknotes
• All central bank reserves
• Unencumbered loans to banks subject to prudential supervision with residual maturities < 6 months
5% • Unencumbered Level 1 assets, excluding coins, banknotes and central bank reserves
15% • Unencumbered Level 2A assets
50%
• Unencumbered Level 2B assets
• HQLA encumbered for a period ≥ 6 months and < 1 year
• Loans to banks subject to prudential supervision with residual maturities ≥ 6 months and < 1year
• Deposits held at other financial institutions for operational purposes
• All other assets not included in the above categories with residual maturity < 1 year.
65%
• Unencumbered residential mortgages with a residual maturity ≥1 year and risk weight ≤ 35%
• Other unencumbered loans (except to financial institutions) with residual maturity ≥1 year and risk weight ≤ 35%
85%
• Other unencumbered loans (except to financial institutions) with risk weights ≥35% and residual maturities ≥ 1 year
• Unencumbered securities that are not in default and do not qualify as HQLA including exchange-traded equities
• Physical traded commodities, including gold
100%
• All assets that are encumbered for a period ≥ 1 year
• Derivatives receivable net of derivatives payable if receivables are greater than payables
• All other assets not included in the above categories, including non-performing loans and others.

20. NSFR: Off-balance sheet categories and associated RSF factors
RSF factor RSF category
5% of the currently
undrawn portion
Irrevocable and conditionally revocable credit and liquidity facilities to any client
National supervisors
can specify the RSF
factors based on their
national circumstances
Other contingent funding obligations, including products and instruments such as:
• Unconditionally revocable credit and liquidity facilities;
• Trade finance-related obligations (including guarantees and letters of credit);
• Guarantees and letters of credit unrelated to trade finance obligations; and
• Non-contractual obligations such as
− potential requests for debt repurchases of the bank’s own debt or that of related
conduits, securities investment vehicles and other such financing facilities;
− structured products where customers anticipate ready marketability, such as
adjustable rate notes and variable rate demand notes (VRDNs); and
− managed funds that are marketed with the objective of maintaining

21. • Sovereign debt is categorized at the top of the liquidity scale to compute RSF
• Additional incentives to hoard high quality sovereign assets
• Effects on sovereign repos: a matched repos have an ASF-factor of zero, with
an RSF-factor of 50 percent.
• Impact on repo costs
NSFR and implications for sovereign debt

22. Central Counter Parties and trading platforms
• The G20 encouraged the standard setters to create incentives to use Central Counter Parties
(CCPs), trading platforms and standardized contracts.
• Shift away from bilateral trading
• The BCBS has materially changed the regime for exposures to CCPs.
• Increase the capital charges associated with bank OTC derivatives and create incentives
for banks to use CCPs.
• The use of sovereign debt as collateral in derivative transactions and CCPs could impact
pricing, as less supply may be available for trading.
• Those assets will be hoarded by dealers as collateral buffers to support OTC transactions.

23. Proprietary trading
• Proprietary trading bans for banks may adversely affect liquidity in
sovereign bond markets.
• The Volcker Rule in the US prohibits banks from engaging in proprietary trading, or
investing in other institutions active in similar activities.
• In the UK and EU, recommendations call for proprietary trading to be conducted in a
ring-fenced manner
• Home sovereign debt is typically excluded, but the reorganization of the
business impacted bank trading activity in sovereign bond markets.
• Proprietary trading is no longer viewed as a sustainable business model

24. Conclusions
• The final overall effect from reforms is still unclear
• Existing capital requirements recognize sovereign assets as a free risk or very
low risk assets
• Pillar II allows to compensate any deficiency
• LR constraints banks’ sovereign exposures. Disincentive for banks to engage in
low-margin and balance sheet intensive activities. Impact on sovereign repo.
• The LCR and the NSFR consider sovereign debt as high quality assets. Incentives
for banks to hoard those assets. Less trading and liquidity in secondary markets.
NSFR potentially increases the cost of repos
• Increasing use of CCPs and margin and collateral requirements could diminish
the availability of government securities.

25. Thank you
Cristina Pailhé
IFD/CMF Consultant
10th Annual Meeting LAC Debt Group
Asunción, Paraguay
11-13 August 2014