Monday, May 3, 2010

Government Bonds – The inherent risks in the balance sheets

European banks and insurance companies hold to a great extend consols (government bonds) from shaky candidates like Portugal, Ireland, Italy, Greece, and Spain. Since these five countries have a history of uncertainty, they are known in the financial market as “Piigs”.

The rate of these bonds as well as their solvency decreased significantly especially due to the downgrade of Greece (and later of Portugal and Spain) by the rating agencies and the following disturbances of the markets. According to the newspapers, a 10-years Greece bond of Greece which was noted in March 2010 with almost its denomination value, can at the end of April only find a purchaser with 82% of its repayment values.

Banks that were heavily involved in the government financing business own lots of these consols, like the now government owned Hypo Real Estate in Germany with 39 billion Euro. However, that does not mean that it has an immediate impact on the balance sheets of the banks (i.e. exposure of their equity ratio). It depends on a complex set of rules.

Is the bond part of the trading portfolio of the bank (those consols that are supposed to be traded on a short-term basis) then the volatility of the stock price will have an immediate effect on the profit and loss statement.

Financial services organizations also need to have a foundation of liquid assets. Since government bonds are usually considered to be sound investments – even from the PIIGS countries – they can often be found in the liquidity reserve to serve short-term payment obligations of the organization. The problem here is the same as with the trading portfolio, changes directly impact the P/L.

As a counter measure, to avoid the effect and to reduce the risk of negative impacts on the balance sheet, banks often moved these consols positions into different portfolios, as asset investments. With this trick the investments are labeled as long-term positions with the consequence that the bank can wait with adjustments of their financial statement till the government of the bond is unable to pay the interest or – as a measure of debt refunding – is reducing the repayment value of its debts (called haircut). But that scenario is not likely as the countries of the European Union are willing to help Greece with around 110 Billion Euro of instant loans.

The solvability and Basel II rules demand from financial institutions to hedge their security portfolio with equity in their balance sheet. If the securities rating are going from bad to worse, more and more equity is required as a safeguard. However, government bonds underlie special regulations. As long as the European banks follow the standard principles of capital adequacy, i.e. accessing only external ratings, they do not have to allocate any equity for consols coming from countries of the European Union!

While bonds issued by a company with the same rating as Greece at the moment would result in a requirement to reserve 8% equity on the balance sheet of the holding financial institution, none of this applies to the Greek bonds, under the premises of using standard external ratings. Larger banks, though, do not fully rely on external ratings; they consult in addition their own rating models and hence have to comply with different rules.

Some institutions have therefore most likely added more equity as a risk provisioning due to the lowering creditworthiness of Greece. Most others however, did not follow that path and appeal to the fact that companies that follow their own rating guidance in general can still assess parts of their portfolio according to external ratings. Allianz, the German insurance heavy-weight for example, has heavily invested in Piigs-bonds but still does not see a reason for depreciation, since none of them has defaulted yet.

What does that mean for the industry?

The European governments are trying to get voluntary support from the private banks to take on parts of the credit burden. The financial institutions have a lot of risk hidden in their balance sheets that is not hedged by equity reserves. That is why they may be willing to help the EU to some extent, but I doubt that they will accept taking on a large portion of the additional credit risk, they will leave that to the politicians.

Even though most financial services and insurance companies used the accounting standards to their advantage, avoiding additional equity reserves as risk mitigation for the unsafe consols, they are aware of the risk involved. This leads to additional reporting needs:

· Companies always differentiate between external and internal reporting to cater to the various stakeholders’ needs. The authorities are interested in a public view of the business according to the accounting standards, while the internal view gives the management a different overview based on other criteria.

· The principles for external reporting follow tax law and other regulations, like Basel II compliance. External reporting is therefore strict and formalized. The accounting tricks mentioned above are reflected in the external reporting.

· Internal reporting on the other hand is more flexible. Here the management can use the reporting for strategic purposes, for different views of the business (e.g. using an organizational structure to-be) and is not limited in the usage by regulations. The added risk of government bonds is taken into account and separately shown in the balance sheet. In addition, it is very likely that the executives want to see specific dashboards qualifying the impact of government bonds in terms of value at risk.

1 comment:

  1. Great thoughts you got there, believe I may possibly try just some of it throughout my daily life.

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