London - European Union policymakers paved the way for the region's banks to load up on US municipal debt by creating a loophole that lets them hold minimal capital against the bonds of local authorities like Detroit, which buckled last month under debts of $18.5 billion.

EU banks, including bailed-out Belgian lender Dexia , could together face hundreds of millions of euros of losses from the bankruptcy of Detroit.

Dexia alone has set 59 million euros aside to deal with its potential losses, while German banking giant Commerzbank told investors on Aug. 8 that it had taken a “substantial number” as a writedown on its Detroit holdings but declined to say exactly how much.

There is concern that Detroit's filing could eventually create legal precedents that could encourage some cities with a heavy pension and health benefits burden to take a similar route, leaving their lenders nursing losses.

The exposure of Europe's banks to Detroit's debt came as a surprise to some, since unlike US investors, EU banks do not enjoy tax-free income on “muni” bonds issued by US cities, states and other public sector entities.

What they do enjoy, however, is a favourable EU application of global bank capital rules that allows banks to hold only a small amount of capital to cover potential losses on local authority bonds as long as the country in which the municipalities are based has a strong rating.

This means banks can earn high returns from a lowly rated muni bond in a highly rated sovereign without worsening their capital ratios, a neat trick when regulators are demanding higher capital cushions and interest rates are at record lows.

That treatment was first enabled by the Basel II capital rules, which give banks the option of applying either the usual credit-quality-based approach to assigning risk weights to municipal bonds, or a 'standardised' approach that assumes they are only slightly riskier than the debt of its home country.

Capital ratios are calculated as capital divided by risk-weighted assets, so the lower a bank's risk-weighted asset figure, the higher its capital ratio. Hence the standardised model for munis almost always leads to better capital figures than banks' internal models, allowing them to take on more risk elsewhere or flatter their safety profiles.


However, a senior regulator told Reuters the Basel II rules were not intended to be applied in the way they were transposed into European law. The EU package, dubbed CRD III, lets even the biggest banks who use their own internal models to assess the riskiness of the rest of their books - which tend to produce a lower risk weighting for other assets - to use the standardised models to assess the riskiness of their municipal bonds.

The Basel version of the rules allowed this exemption for a transitory period only - the European version permanently enshrined it in law. Several banking sources told Reuters that the low risk weightings were a key factor in their decision to buy muni bonds. Figures from the US Treasury show that non-US investors held $63.7 billion of munis at the end of March.

The senior regulator said banks and European authorities were expected to apply “common sense” and only allow low risk weightings for municipal debt that was actually low risk. He added that banks should considering much more than just the regulatory capital impact when they buy debt - such as whether a bond is a good investment or not.

The suitability of the standardised approach, and its facilitation of the assumption that municipalities carry the same risk as their sovereigns, could be reviewed by the Basel Committee of International Supervisors.

“There was a lot of debate around this when Basel II was being introduced,” said Steven Hall, a London-based partner in KPMG's Financial Risk Management practice. “Where you have a regional government that can do its own revenue raising, it can go out and print money, it can raise revenue to pay back its debt.

“So there is a need to be able to differentiate between these kind of institutions and other public sector entities. Whether this is equivalent to central government risk is a further step and will be a matter of regulatory judgment in each jurisdiction.”


For now, EU banks get to choose.

The continent's largest, HSBC, which holds about $800 million of US municipal debt through its North America Holdings company, uses its internal models, not the standardised approach, a person familiar with the matter told Reuters.

Spain's Santander, which held about $2 billion of US state and municipal securities at the end of June, declined to comment on how it treats its holdings. A spokesman said the portfolio had a weighted average underlying credit risk rating of AA as of June 30, a rating that makes them one of the safest securities an investor can buy.

Fellow Spanish bank BBVA had about $1.4 billion worth of securities issued by states and political subdivisions in the United States as of March 31. A spokesman said a “significant portion” of the holdings were muni bonds but could not say exactly how much or what the other holdings were.

“Of the muni bonds held, 1/3 are AAA and 1/2 of the total are rated between AA+ and AA-,” he added. “We are very comfortable with the position.”

The holdings of those three banks were reported in US regulatory filings that are only required for banks that have more than $500 million of assets in US holdings company. Other banks do not disclose their holdings.

The overall exposure of European banks is unclear. German regulator Bafin said on July 29 that its banks and insurers had 18.5 billion euros' worth of exposure to US municipalities. Italian banks have about 800 million euros' worth, a source familiar with the matter told Reuters.

A spokeswoman for French regulator ACP said their banks have “non-significant exposure on Detroit and very limited exposure on other US muni bonds”. Regulators in Switzerland, the UK and Spain declined to disclose their banks' exposure, or say whether they were concerned about it in light of events in Detroit.

A senior European credit trader said investors, not banks, were the major European buyers of US and international municipal debt, lured by its attractive returns and relatively low risk.

The European Banking Authority (EBA) did not consider the risk of US municipal bonds defaulting when it carried out its last review of banks' capital positions in 2012, since this review was primarily focused on the eurozone debt crisis. US municipal debt was given the same treatment as any other sovereign debt in the 2011 stress tests.

While the implosion of Detroit's finances has caused alarm about muni holdings, it is in some ways an isolated case.

“I do not think the Detroit financial mess is indicative of the US muni market in general,” said Alan Schankel, a Philadelphia-based muni bonds expert at Janey Montgomery Scott.

Some of Detroit's problems, like low pension funding and high costs of post retirement healthcare, are common to other municipal issuers, Schankel said, but Detroit was also the victim of a unique population collapse. It now has just 690,000 inhabitants, against 951,000 in 2000 and 1,850,000 in 1950, robbing the city of its income base.

That may reassure some European bank investors wondering if their institution is about to be stung. But it's too late for the taxpayers of Belgium and France, who will foot the bill for the losses Detroit ultimately imposes on state-controlled Dexia. - Reuters