* EU rules flatter capital ratios of banks holding munibonds
* German banks and insurers holding 18.5 billion euros ofmunis
* Italian banks have 800 million euros of muni exposure
* HSBC, Santander and BBVA all have exposure of $800+ mln
By Laura Noonan
LONDON, Aug 12 (Reuters) - European Union policymakers pavedthe way for the region's banks to load up on U.S. municipal debtby creating a loophole that lets them hold minimal capitalagainst the bonds of local authorities like Detroit, whichbuckled last month under debts of $18.5 billion.
EU banks, including bailed-out Belgian lender Dexia, could together face hundreds of millions of euros oflosses from the bankruptcy of Detroit.
Dexia alone has set 59 million euros aside to deal with itspotential 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 butdeclined to say exactly how much.
There is concern that Detroit's filing could eventuallycreate legal precedents that could encourage some cities with aheavy pension and health benefits burden to take a similarroute, leaving their lenders nursing losses.
The exposure of Europe's banks to Detroit's debt came as asurprise to some, since unlike U.S. investors, EU banks do notenjoy tax-free income on "muni" bonds issued by U.S. cities,states and other public sector entities.
What they do enjoy, however, is a favourable EU applicationof global bank capital rules that allows banks to hold only asmall amount of capital to cover potential losses on localauthority bonds as long as the country in which themunicipalities are based has a strong rating.
This means banks can earn high returns from a lowly ratedmuni bond in a highly rated sovereign without worsening theircapital ratios, a neat trick when regulators are demandinghigher capital cushions and interest rates are at record lows.
That treatment was first enabled by the Basel II capitalrules, which give banks the option of applying either the usualcredit-quality-based approach to assigning risk weights tomunicipal bonds, or a 'standardised' approach that assumes theyare only slightly riskier than the debt of its home country.
Capital ratios are calculated as capital divided byrisk-weighted assets, so the lower a bank's risk-weighted assetfigure, the higher its capital ratio. Hence the standardisedmodel for munis almost always leads to better capital figuresthan banks' internal models, allowing them to take on more riskelsewhere or flatter their safety profiles.
WIN-WIN
However, a senior regulator told Reuters the Basel II ruleswere not intended to be applied in the way they were transposedinto European law. The EU package, dubbed CRD III, lets even thebiggest banks who use their own internal models to assess theriskiness of the rest of their books - which tend to produce alower risk weighting for other assets - to use the standardisedmodels to assess the riskiness of their municipal bonds.
The Basel version of the rules allowed this exemption for atransitory period only - the European version permanentlyenshrined it in law. Several banking sources told Reuters thatthe low risk weightings were a key factor in their decision tobuy muni bonds. Figures from the U.S. Treasury show thatnon-U.S. investors held $63.7 billion of munis at the end ofMarch.
The senior regulator said banks and European authoritieswere expected to apply "common sense" and only allow low riskweightings for municipal debt that was actually low risk. Headded that banks should considering much more than just theregulatory capital impact when they buy debt - such as whether abond is a good investment or not.
The suitability of the standardised approach, and itsfacilitation of the assumption that municipalities carry thesame risk as their sovereigns, could be reviewed by the BaselCommittee of International Supervisors.
"There was a lot of debate around this when Basel II wasbeing introduced," said Steven Hall, a London-based partner inKPMG's Financial Risk Management practice. "Where you have aregional government that can do its own revenue raising, it cango out and print money, it can raise revenue to pay back itsdebt.
"So there is a need to be able to differentiate betweenthese kind of institutions and other public sector entities.Whether this is equivalent to central government risk is afurther step and will be a matter of regulatory judgment in eachjurisdiction."
UNDISCLOSED EXPOSURE
For now, EU banks get to choose.
The continent's largest, HSBC, which holds about$800 million of U.S. municipal debt through its North AmericaHoldings company, uses its internal models, not the standardisedapproach, a person familiar with the matter told Reuters.
Spain's Santander, which held about $2 billion ofU.S. state and municipal securities at the end of June, declinedto comment on how it treats its holdings. A spokesman said theportfolio had a weighted average underlying credit risk ratingof AA as of June 30, a rating that makes them one of the safestsecurities an investor can buy.
Fellow Spanish bank BBVA had about $1.4 billionworth of securities issued by states and political subdivisionsin the United States as of March 31. A spokesman said a"significant portion" of the holdings were muni bonds but couldnot say exactly how much or what the other holdings were.
"Of the muni bonds held, 1/3 are AAA and 1/2 of the totalare rated between AA+ and AA-," he added. "We are verycomfortable with the position."
The holdings of those three banks were reported in U.S.regulatory filings that are only required for banks that havemore than $500 million of assets in U.S. holdings company. Otherbanks do not disclose their holdings.
The overall exposure of European banks is unclear. Germanregulator Bafin said on July 29 that its banks and insurers had18.5 billion euros' worth of exposure to U.S. municipalities.Italian banks have about 800 million euros' worth, a sourcefamiliar with the matter told Reuters.
A spokeswoman for French regulator ACP said their banks have"non-significant exposure on Detroit and very limited exposureon other U.S. muni bonds". Regulators in Switzerland, the UK andSpain declined to disclose their banks' exposure, or say whetherthey 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 U.S. and internationalmunicipal debt, lured by its attractive returns and relativelylow risk.
The European Banking Authority (EBA) did not consider therisk of U.S. municipal bonds defaulting when it carried out itslast review of banks' capital positions in 2012, since thisreview was primarily focused on the eurozone debt crisis. U.S.municipal debt was given the same treatment as any othersovereign debt in the 2011 stress tests.
While the implosion of Detroit's finances has caused alarmabout muni holdings, it is in some ways an isolated case.
"I do not think the Detroit financial mess is indicative ofthe U.S. muni market in general," said Alan Schankel, aPhiladelphia-based muni bonds expert at Janey Montgomery Scott.
Some of Detroit's problems, like low pension funding andhigh costs of post retirement healthcare, are common to othermunicipal issuers, Schankel said, but Detroit was also thevictim of a unique population collapse. It now has just 690,000inhabitants, 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 iftheir institution is about to be stung. But it's too late forthe taxpayers of Belgium and France, who will foot the bill forthe losses Detroit ultimately imposes on state-controlled Dexia.
HSBC Holdings (HSBA)