Mr Pierschel, why did the BCBS decide to review the rules regarding sovereign exposures?

The regulations on sovereign exposures form part of the Basel framework on credit risk. Accordingly, they were originally intended to be reviewed as part of the revision of this framework. However, in light of discussions held during the BCBS's work and against the backdrop of the sovereign debt crisis, the Basel Committee decided to set up a separate Task Force in order to avoid the risk that a review of the standardised approach for credit risk or of the IRBA might be undermined entirely.

Why undermined entirely? Are the differences of opinion so great?

Yes, indeed they are. There is a north-south problem, both within Europe and globally. Quite frankly, northern countries recognise the urgent need to abandon zero risk-weighting. A number of countries, particularly in the south, are less ambitious in this respect.

Why do you consider it important to move away from zero risk-weighting?

Leaving it in place would be negligent. This is a matter of reducing the interdependencies between state financing and banks. Zero risk-weighting results in concentrations of sovereign exposures in bank balance sheets that we, as supervisors, must regard as unhealthy. After all, there certainly is not zero risk. Using the IRBA modelling approach, even German government bonds are risk-weighted at 1 to 1.2%. European national discretions nonetheless also allow IRB institutions to apply the Standardised Approach for sovereign exposures within the framework of "permanent partial use". And for loans denominated in the domestic currency the result is: zero risk weight. Therefore, if a bank from a eurozone country grants a loan to its own country or another eurozone country, then the zero risk-weighting will apply to those exposures.

What is the opposing view?

A zero risk weight allows credit to be granted without the restriction that the bank has to hold corresponding capital; the only constraint here is the leverage ratio. Many southern countries, as well as some in the north, have made full use of this, resulting in a degree of interconnectedness that can have negative implications for both banks and states, specifically when the unspeakable happens and a state is unable to settle its debt, as most recently in the case of the partial default on Greek government bonds.

Of course, these countries know this. But they also know that prohibiting zero risk-weighting of these positions in bank balance sheets would result in substantial capital or large exposure requirements. And this could considerably reduce credit institutions' willingness to continue financing states.

Against this backdrop, what is your assessment of the discussion paper?

First of all, we are happy that the discussion paper has been published at all. In view of the differences of opinion, this was by no means a certainty. The document also presents the German position and contains numerous points for consideration and discussion.

What are the key points?

Alongside definitions, the paper addresses several topic areas representing various, to some extent combinable, approaches. One approach is to leave everything as it is. Following the discussions in the BCBS, however, this has already been dismissed: all member states are in agreement that, where sovereign exposures are concerned, we must seek to implement changes to Pillar 3, i.e. to the disclosure requirements. We need more detailed information. Although we were able to measure public liabilities with relative accuracy during the sovereign debt crisis, we had no overview of how much of this debt was attributable to central government and how much to public sector entities.

Another topic area concerns the approach of treating sovereign risks according to Pillar 2, i.e. considering them on the level of the individual institution. Finally, two chapters address the points that are most important to us: risk-weighting and large exposure limits. In addition to this, the paper details a further point of contention: the suggestion that sovereign exposures no longer be modelled under the IRBA.

Why this suggestion?

The backdrop to this is a problem we have already encountered with operational risks: the banks do not have sufficient individual loss data to facilitate independent risk modelling. As a result, they are ultimately reliant on the same external databases as supervisors and central banks. This is why, in the case of operational risk, we specified how risks should be calibrated.

Nevertheless, in our view, as long as there is no stricter standardised approach, there is no alternative to the IRBA for sovereign exposures. It is currently the only workable method of generating risk-weightings that are clearly in the positive range.

Which solution is best from a German perspective?

We need a revised definition that clearly specifies what qualifies as sovereign exposures to be held in the banking books and what should therefore be given preferential risk-weighting. Germany's aim is to put an end to zero risk-weighting of sovereign debt. This could be achieved both through positive risk-weighting and through a large exposure limit. The European Parliament commissioned a study whose authors propose relatively stringent large exposure limits – this would certainly be a possibility.

We would favour the hybrid approach developed on the basis of the German proposal. In principle, ratings-based risk-weighting could be used as a basis here. Risk weight add-ons would then be applied beyond a certain large exposure threshold. Of course, we would also have to work on the definitions. In order to precisely define the large exposure limit, there must be clear rules regarding groups of connected clients. The Federal Ministry of Finance has submitted its comments to the BCBS regarding this matter.

The deadline for submitting comments expired a few days ago. Have you been able to obtain an overview of the responses yet?

One thing can be said already: the BCBS has received a lot of feedback from a broad range of respondents. We are very happy about that. One reason for the high level of participation was undoubtedly the fact that it will become increasingly difficult for countries with poorer ratings to secure refinancing in future if the treatment of sovereign debt is not changed. This is because, according to the new standardised approach for credit risk, sovereign bonds would be given the same risk-weighting as risks arising from bank exposures with a rating of BBB or lower and corporate exposures with a rating of BB or lower. This has galvanised both proponents and opponents of regulatory reform.

What happens next?

Firstly, the BCBS will publish the comments on its website. It will then examine and evaluate them before providing an overview of the answers. EU member states in particular will look very carefully at this. From the answers, we will be able to gauge which points are important to other national authorities, whether this be debt management agencies, supervisory authorities or central banks. This is elementary for the continued discussions regarding risk-reduction measures, which are currently being held in Brussels in connection with the European Deposit Insurance Scheme.

How is this related to sovereign exposures within the framework of Basel III?

The European deposit insurance scheme is closely linked to the issue of sovereign debt. A key German demand is that sufficient risk reduction measures must be taken before this scheme can be implemented. From our perspective, this must first and foremost include positive risk-weighting for sovereign exposures. Whether and how this progresses in Basel will, in turn, no doubt also depend on whether we in Europe can reach a solution.

Are we not running around in circles here?

Yes, it's the classic chicken-and-egg problem: the EU member states are waiting for Basel and Basel, in turn, can only really act once the EU member states have reached a consensus. The question is, therefore: who makes the first move? In spite of this, I am optimistic that we in Europe will make progress. And if, one day, we develop a common European solution that is genuinely supported by all, then we can move things forward in the Basel Committee.

Until then, I can at best imagine the BCBS will make minor adjustments, possibly in the form of risk weight reductions for poorly rated countries. The current situation will certainly not bring about any progress, in particular where definitions are concerned, which is an area in urgent need of review. The most important definitions are still wide open. Everyone has their own interpretation of "public sector entities", for example. In order to keep the framework as consistent as possible, however, we need standardised definitions.