In the mayhem following the Brexit vote on June 23, the focus was on traders' attempts to minimise losses and stabilise their positions. But some bank treasurers were also feeling the pinch. The choice by some regulators – including those in the UK – to pre-emptively strip filters protecting regulatory capital from changes in the value of sovereign bonds meant that widening credit spreads had the potential to take a bite out of banks' Tier 1 capital holdings.
In the first few frantic hours after markets opened on June 24, the primary concern for some treasurers was how their so-called available-for-sale (AFS) portfolio, where liquidity buffers are held, was going to look at the end of the day.
While gilt yields actually fell on the news and spreads on vulnerable periphery sovereigns settled at a lower level than expected, the initial dread felt by treasurers will become more common following stress events as these filters eventually get phased out across the world as a result of Basel III.
Government bonds held in a bank's liquidity buffer are often stored in AFS portfolios – a halfway house between the traded portfolio, which directly impacts a bank's earnings, and the held-to-maturity portfolio, which holds assets that stay with the bank for their life. Unrealised gains and losses on AFS portfolios are accounted for in the accumulated other comprehensive income (AOCI) section, which sits in the equity portion of the balance sheet and doesn't impact earnings.
While in the past these AFS valuation changes were filtered out of regulatory capital, Basel III explicitly requires all AOCI items to count towards Common Equity Tier 1 capital. European regulators, however, allowed member states to retain the filter for government exposures until the new International Financial Reporting Standard 9 is adopted in the region. Only the UK, Greece and Sweden chose to go ahead with removing the filter ahead of time.
If you've got a hit on regulatory capital, you have an immediate crisis you have to do something about
Daniel Davies, Frontline Analysts
For those three countries, the Brexit vote was the first time treasurers had to manage the impact of AFS volatility on regulatory capital in a time of stress since the filters were removed in 2014 – a situation that can be potentially worrying for treasurers.
"If you've got a hit on regulatory capital, you have an immediate crisis you have to do something about. If you just have a hit to equity, it kind of sucks, and obviously you would much rather have had that money, but it doesn't really affect the bank's ability to do business," says Daniel Davies, managing director of equity at independent research firm Frontline Analysts.
Thankfully for these banks, the Brexit effect was muted: UK gilt yields fell slightly after the referendum result as investors rushed to the asset in expectation of a rate cut. Barclays, for example, holds €95 billion ($106 billion) in sovereign exposures in its AFS portfolio, according to the 2015 European Banking Authority (EBA) transparency exercise, of which around €27 billion is linked to the UK government.
Treasurers at banks in other European countries could safely ignore the issue as their filters ensured the AFS volatility did not hit regulatory capital. That is probably good for treasurers' health – the day after the Brexit vote, yields on 10-year Italian bonds climbed from 1.32% at closing the day before to a high of 1.6%, while Spanish bonds moved from 1.47% to around 1.69%. Both subsequently moved back down to 1.48% and 1.64%, respectively, by market close.
Fast forward a few years though and these types of market movements could cause real problems at banks in the eurozone periphery, particularly in Italy and Spain. These banks feel strong pressure to hold domestic government bonds in their liquidity buffers, which, in turn, makes them vulnerable to stress events.
The EBA's transparency exercise shows that at Italy's Banca Monte dei Paschi di Siena, €19.1 billion of its €19.3 billion AFS sovereign exposures – nearly 99% – are to the Italian sovereign. At UniCredit, the figure is 57%. All four UK banks in the test had only a combined €276 million of exposure to Italy.
Spanish banks, meanwhile, hold almost €50 billion in Spanish AFS sovereign exposures, compared to a little more than €200 million at the UK banks. A spike in yields could cause huge movements in these banks' AFS portfolios, taking chunks of regulatory capital with it at a time of crisis.
So, when the filters are eventually removed and the next unexpected market event hits, it's likely that treasurers in these countries will be as glued to the bond yield movements as the traders.