OREANDA-NEWS. Changes to the capital treatment of sovereign risk could force eurozone banks either to raise up to EUR135bn in additional capital to maintain solvency levels or to reallocate EUR492bn of eurozone sovereign holdings to stick to new limits, Fitch Ratings says.

Proposals to subject EU sovereign exposures to capital requirements and/or large exposure limits were discussed by EU Finance Ministers in April 2016. The changes are intended to reduce banks' exposures to their own sovereigns, as part of a package of measures to strengthen the EU's banking union, and ahead of possible future proposals from the Basel Committee.

Data from the European Banking Authority's 2015 transparency exercise, which represents 70% of EU banking system assets, showed that EU banks had EUR2.3trn sovereign exposures of which 65% was to the 'home' sovereign at end-1H15.

We assess the impact of the proposals under five scenarios, largely based on options already publicly considered by EU officials. The impact of applying a flat 10% risk-weight across eurozone banks' EU sovereign exposures would be a relatively modest increase in capital requirements of almost EUR12bn to maintain capital ratios.

However, an approach designed to penalise excessive concentrations could create requirements of EUR135bn. This scenario capitalises banks' sovereign holdings using external ratings, with a minimum 10% risk-weight floor. It then applies an increasing set of capital charges to any sovereign exposures above 100% of a bank's capital. The increasing charges are based on the EU's existing regime for capitalising excess exposures above the large exposures limit, which is normally set at 25% of a bank's capital.

If reforms are introduced, banks could respond by selling domestic sovereign exposures, or they could keep their existing sovereign bonds and hold additional capital. Most likely, banks would gradually shift portfolios towards suitable substitutes, weighing up the capital carrying cost versus yield, assessing the impact on profitability and considering whether new securities are eligible for liquidity buffer requirements.

In practice, this latter approach would lead to banks altering the mix of their sovereign portfolios to shift partly out of their home sovereign and into other eurozone government debt.