Sovereign bond cuts on agenda

European governments look set to lose the backing of their biggest group of creditors, with some of the region’s banks likely to trim the €1.72tn they own in low-yielding government debt in coming quarters, in a bid to boost profitability.

Banks have become increasingly important buyers of sovereign debt, with increased purchases helping to offset an exodus of foreign buyers. A decline in bank appetite could leave governments exposed to rising yields at a time when many still have large deficits to finance in the market.

A need to boost profit levels to meet new minimum capital levels is driving the switch, with some treasurers — mainly banks in the UK, Germany and France that have excess liquidity — concluding that low yields are no longer sufficient and that a re-balancing of portfolios is needed.

“Some banks are concluding they now have too much liquidity,” said Bridget Gandy, managing director in the financial institutions group at Fitch. “The crisis mentality is ebbing and the pressure is on to increase profitability, and we’re going to see some selling out of low-yield liquid assets.”

According to Gandy, the outlook for profitability is still weak for banks in Spain and Italy, and is poor to moderate in most other European countries. Impairments continue to eat into earnings — consuming more than 20% of revenues for Italian and Spanish banks — while interest margins are low. “There is a lot of pressure on bank earnings from low rates,” she said. “Some are concluding that they no longer need to hold so much liquidity, and it’s likely they will shift such funds to higher-yielding activities such as lending.”

Banks will, of course, keep substantial holdings of government debt, partly because they aren’t required to hold capital against most government bonds. Still, given their large holdings, even a partial reduction could push yields higher.

Banks in the European Union have steadily increased their holdings of government debt over the past few years. European Central Bank data show that banks owned a record €1.72tn of sovereign bonds in April, up by about a quarter in the past 18 months and 40% higher than before the onset of the financial crisis.

The dash into government debt has been partly driven by new liquidity rules, which force banks to hold large buffers of liquid assets to tide them over during times of acute market stress.