Jens Weidmann, the Bundesbank president, is right to put this topic on the agenda. After all, the exposure of banks to governments is one half of what has been dubbed the sovereign-bank doom loop. When governments such as Greece got into trouble, they dragged their banks down as well. (The other half of the doom loop involves troubled banks dragging down their governments.)
The problem is how to break this loop without triggering a new crisis in vulnerable countries such as Italy and Spain. After all, if their banks were suddenly told to cut their holdings of Italian and Spanish bonds, Rome and Madrid would be hard-pressed to fund themselves.
Weidmann mentioned two rules that encourage banks to load up on government debt in an article in the Financial Times.
First, banks holdings of sovereign debt are exempt from the so-called large exposures regime. This says banks are not allowed to lend more than a quarter of their eligible capital to any single counterparty. The basic principle is lenders are less likely to get into trouble if they dont have too many eggs in one basket.
Second, banks normally have to set aside a slice of capital against any loan they make as a buffer in case it goes bad. But their sovereign exposures have low or zero capital requirements.
Both these regulatory privileges, which are standard practice around the world, are justified by the idea that sovereign debt is risk-free. Whatever one thinks about this notion in other parts of the world, it is clearly not the case in the eurozone as individual governments there cannot print money to get out of a debt crisis. Whats more, the debt of some governments such as Greeces is clearly riskier than the debt of others.
This regulatory favouritism meant banks loaded up with sovereign debt before the crisis. In Italy and Spain, they also increased their exposure during the crisis. Foreign bondholders fled from the periphery, meaning the domestic banks had to take up the slack.
The ECB helped this process by giving banks unlimited supplies of cheap long-term loans two years ago. Much of the money was recycled into buying government bonds, which carried a higher interest rate. This might have been seen as doubly risky. But, from the perspective of a bank that was already up to its eyeballs in its own governments debt, it was quite logical. After all, if their country went bust, they were damned anyway. So why not hope for the best and earn a bit of a profit in the meantime
Weidmann rightly lambasted this practice not just for its riskiness, but also for reducing market discipline. Governments are under less pressure to reform their economies because they can get money from their lenders; and banks are under less pressure to run good operations because they can easily get money from the ECB.
Before the crisis, the ECB didnt have much of a role in addressing the doom loop. But, from next year, it will be in charge of bank supervision throughout the eurozone. Although this will give it the power to stop the bad practice, its not yet clear whether Weidmann, who is only one voice on its governing council, will carry the day. Mario Draghi, the ECB president, said last week that views about the different riskiness of government bonds are personal opinions. He seemingly implied that the ECB as a group hasnt yet focused on the matter, though his remarks were not a direct response to Weidmans comments.
The ECB may be tempted to avoid discussing the matter at all, in the belief that the priority is to calm things down not raise yet more doubts among investors about how governments will fund themselves. But the topic should not be put off forever, and the natural time to examine it is as the ECB gets its new supervisory powers.
But what exactly to do Weidmann didnt spell out what he thought was needed. But he strongly hinted that both sovereign debt privilegesthe exemption from the large exposures regime and the low or zero capital requirementsshould be phased out.
Capping the amount of sovereign debt a bank can hold would be the bigger change. Weidmann rather optimistically said that governments borrowing costs could ultimately fall as there would then be less risk that they might in future have to bail out their lenders. More likely, borrowing costs will rise. It would therefore be sensible to take a decade or so to bring in this change.
Pushing up capital requirements raises another issue, as the ECB would have to discriminate between the riskiness of different governments debt. Contracting out the job to either credit rating agencies or the market wouldnt be a good idea. But if the ECB itself pronounces on the relative riskiness of bonds, that could cause a political storm in those countries deemed especially risky. That said, it is supposed to be an independent institution. The ECB should have the courage to do its job properly.
Hugo Dixon is Editor-at-Large, Reuters News