Set Up to Fail by Basel
“Under the Basel rules [international bank regulations], sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight. Holding sovereign debt provides banks with interest-earning investments that do not require them to raise any additional capital.
Accordingly, when banks in Europe and elsewhere were pressured by supervisors to raise their capital positions, many chose to sell other assets and increase their commitment to sovereign debt, especially the debt of weak governments offering high yields…”
The next time you are left wondering how Europe could be collapsing, think about the regulatory structure it placed itself into. In order to (supposedly) increase the safety and soundness of their banks, regulators required them to hold certain amounts of capital against their assets. Sovereign debt was artificially deemed to be “risk-free,” and so no capital had to be held against these assets.
This was a recipe for failure in the long run. Over the short run, however, everyone involved was perfectly happy with the system:
- Banks were willing buyers of debt, because they got to hold the paying assets on their books with no capital reserves, and with the explicit support of their government regulators.
- The governments issuing sovereign debt were able to issue at artificially low rates to these willing bank buyers because of the artificially lower cost to hold the debt, which itself was imposed by regulations adopted by the governments selling the debt.
- The citizens of the issuing countries got to finance their elaborate welfare states on the strength of their countries’ ability to borrow at artificially low rates, held artificially low by the lower cost to hold the debt to willing bank buyers, artificially imposed by regulations adopted by the governments selling the debt.
It took only a few short steps from “prudential” regulation to national profligacy. Of course, no system built on the expectation of perpetual easy money can survive the long haul. Because eventually, there is no more money.
A system like this will work until it stops working. What happens next is anyone’s guess. My thought is that the Europeans can (and will) kick the can down the road again. There will likely be some more moderate deleveraging, but there is no political will, especially in Europe, the solve the problem.
Unfortunately, this means that the next time the system stops working, the problem will be even worse.