LONDON, Sept 10 (Reuters) - Some European banks being checked by regulators for signs of capital weakness may be sitting on up to a trillion dollars of potentially unsafe assets because their holdings of sovereign bonds are not being fully risk assessed, a new study has found.
Post-financial crisis, banking watchdogs have regularly submitted banks to an examination of their assets to ensure they could withstand another shock to the global banking system. But the last two so-called stress tests failed to scrutinise banks' exposure to government bonds and despite criticism, regulators still cannot fully assess these holdings because international rules let banks consider them risk free.
The result, according to a new study that could have implications for the credibility of the latest bank tests, is that 64 of Europe's biggest banks may be holding a total of 806 billion euros ($1.04 trillion) of risk weighted assets that are linked to sovereign bonds - rather than the zero amount that regulators are counting on.
Risk weighted assets - gauging holdings according to their likelihood of default - matters because the capital requirements now demanded of banks post-financial crisis demand this rather than a simple balance sheet snapshot. The refinement was introduced by global banking watchdogs to make sure lenders were acknowledging their real risk profile and putting aside enough capital to cover any losses resulting from it.
In short, banks could pass the latest round of testing - the results are due to be announced in October - and still have "too little capital or at least too little excess capital (than if they had to recognise the sovereign risk)," said Prof. Sascha Steffen of Berlin's European School of Management and Technology (ESMT), author of the study with Dr Josef Korte of the Goethe University in Frankfurt.
The study is likely to be seized upon by critics of current EU banking legislation.
The EU's treatment of banks' sovereign debt has been castigated by the committee of international watchdogs that drew up Basel, which intended to force banks to take a realistic assessment of risk in their holdings - but also allowed bonds issued by a bank's own country in the country's own currency to be considered risk free. The logic was that countries could print money to honour their own bonds, and likely would.
EU policymakers, with an eye on common market law, extended those rules to allow banks to treat as risk free any sovereign bonds issued by other EU countries. This was to encourage banks to hold high levels of government debt and provide a stable funding base for countries still grappling with massive deficits - and also ensure banks had a high supply of liquid assets, another objective of policy makers.
That, said Steffen, has created a situation that makes the financial sector riskier. As a group, banks are too heavily invested in sovereign bonds because they're all following the EU's incentives and because "banks do accumulate too much risk if they do not have to hold ...capital which reflects the economic risks".
An ECB spokesman said the ECB would not apply a "risk weighting" to sovereign bonds in its Asset Quality Review, an assessment that runs parallel to the stress tests, but added: "The stress tests...which are part of the exercise and which will be taken into account in banks' capital needs, no longer treat sovereign bonds as risk free."
The tests will consider banks' potential losses on sovereign bonds - testing them to see whether for example they could survive a 30 percent fall in the value of some Greek bonds.
Korte and Steffen's research suggests that the risk isn't contained within countries. Of the banks they analysed, about a third of the 'unrecognised' risk weighted assets were in respect of investments in other countries' sovereign bonds.
This can leave a country with hidden exposure to another - raising the prospect of another case like Cyprus, whose banks' exposure to 5.8 billion euros of Greek debt triggered a crisis that forced the island nation into a 10 billion-euro bailout from Europe and the International Monetary Fund.
The banks with the highest levels of sovereign risk - as calculated by the researchers - are from Spain and Italy.
Seven of the ten banks with the highest exposure declined to comment on the research or their positions. Italy's UniCredit , which had the second highest exposure, said it had enough capital to cover its sovereign risk even though it did not have to assign risk weightings for that purpose.
"Moreover our portfolio of sovereign exposures is well geographically diversified," the bank said. "This enables UCG (Unicredit) to face any stress scenario of this part of the book with very high confidence levels."
Italy's Monte dei Paschi, which had the seventh highest exposure, said its total sovereign bond holdings had fallen by a third to 24 billion euros since June 2013. Spain's Caixabank said it considered the study's risk weights for Spanish debt "rather high", but that it still had excess capital to deal with the study's imagined requirements.
In a sign that regulators are already aware of the problem, the head of the European Central Bank's supervisory arm - which takes powers over euro zone banks on Nov 4 - told Estonian newspaper Aripaev recently that the financial crisis taught Europe that there are no truly risk free assets.
"Even sovereign bonds are not risk free. We have to draw the consequences of this in the European regulation as soon as possible," Daniele Nouy said in comments published on Sept. 4.
However Nicolas Veron, an expert on banking regulation at the Bruegel economic think-tank in Brussels and the Peterson Institute in Washington DC, disagreed.
"Sovereign risk no longer exists in the euro zone. There will never be a sovereign default after Greece, which was an exceptional case. Spreads have narrowed because the market consensus is that the next time a euro zone sovereign were to have a problem, governments will find a way of bailing out the sovereign," he said.
"On a 3-5 year horizon, that market consensus is very robust. The authorities are right to test banks' sovereign debt holdings for market risk and not for country default risk."
Opinion is divided on whether the regulators should dissuade banks from holding sovereign bonds by assigning them a risk weighting.
Nick Gartside, international chief investment manager at JP Morgan Asset Management, said though treating sovereigns as risk free was problematic, it also served a purpose.
"You need a risk-free asset from which you can price other assets and government bonds is the starting point," he said, adding that governments in developed countries usually had a strong willingness and ability to pay their debts.
The fact that 2014 bank tests will consider banks' potential losses on sovereign bonds might act as a deterrent to more buying of government bonds, as might market conditions.
"The incentive will get lower now that yields are getting compressed," said Gerard Moerman, head of rates and money markets at Aegon Asset Management.
1 US dollar = 0.7763 euro With additional reporting by Jan Strupczewski in Brussels and Paul Taylor in Paris; Editing by Sophie Walker