Jens Weidmann: Breaking the sovereign-banking nexus
Guest article by Dr Jens Weidmann, President of the Deutsche Bundesbank, entitled "Stop
encouraging banks to load up on state debt" in the Financial Times, published on 1 October
2013.
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It appears to be another case of the "principle of unripe time" - the notion coined by the late
English classicist F.M. Cornford "that people should not do at the present moment what they
think right at the moment, because the moment at which they think it right has not yet
arrived".
The financial and sovereign debt crisis have underpinned the importance of breaking the
disastrous sovereign-banking nexus - in which shaky bank balance sheets degrade the
solvency of their sovereigns, and vice versa. A European banking union is an important step
towards escaping this deadly embrace. To this end, and to complement the banking union, a
reassessment of the regulatory treatment of sovereign exposures of financial institutions is
crucial.
The current and incoming regulatory framework implies preferential treatment of sovereign
exposures in various forms. While bank exposures to a single counterparty are limited, in
principle, to a quarter of their eligible capital, exposures to sovereigns are exempted from
that large exposures regime. Sovereign exposures are also privileged by low or zero capital
requirements.
Preferential regulatory treatment makes it highly attractive for financial institutions to invest in
government bonds - and those of their home countries in particular. During the crisis, this
has become more attractive still. The share of euro-area sovereign bonds in total bank
assets in the eurozone increased over the past five years by one-third - from 4 per cent to
5.3. And in most countries the home bias, which decreased over the first decade of monetary
union, increased again during the crisis.
Average figures mask important differences from bank to bank and country to country.
Recent studies, including one by the Bundesbank, find that larger banks, less capitalised
banks and banks that are dependent on wholesale funding invest more in sovereign bonds
than others. Hence, the more vulnerable banks are, the more they expose themselves to
sovereign debt.
Weak banks invest in high-yield sovereign bonds and refinance at currently low interest
rates. Such "carry trades" sustain the low profitability of those banks and postpone necessary
adjustments of their business model.
The reasons for the increased exposures of banks to their domestic sovereigns may vary:
the search for yield, moral suasion, the endeavour to stabilise their own respective
sovereigns or simply strategic considerations. In an economy in which the sovereign
defaults, banks are likely to default, too. Thus, the domestic banks have an incentive to
invest in sovereign's bonds and earn the yield mark-up if things go well. What happens in the
event of a joint sovereign-bank default is not relevant for them. This undermines market
discipline for governments and reduces their incentive to carry out necessary structural
reforms. On the other hand, banks, which can obtain unlimited cash against sovereign
collateral from the central bank, are protected from discipline from investors who provide
funding.
Large sovereign bond exposures might also harm the real economy. Rises in sovereign risk
are transmitted into reduced bank lending. Banks that were highly exposed to strained
European sovereign debt have reduced their lending to the private sector.
Thus, the current regulatory treatment is incompatible with the principle of individual
responsibility; the market interest rate no longer reflects the riskiness of the investment. I am
aware that banks as well as governments are afraid of rising funding costs as a result of
ending the regulatory privileges afforded to sovereigns. The argument goes, moreover, that
such a regulatory move risks considerable market turmoil. I do not think that this argument
should keep us from doing the right thing.
No market participant would judge a French bond to be as risky as a Greek one: the
riskiness of each is reflected in their prices. Investors believe that sovereigns differ in terms
of riskiness. So no one should be surprised when the regulatory treatment accommodates
this fact.
If additional capital requirements for European banks were imposed to cover sovereign
exposures, the extra capital would be almost negligible on aggregate - albeit with substantial
differences between banks. Other measures, such as the inclusion of sovereigns in the large
exposures regime might lead to more substantial repercussions, but these would be
manageable if introduced over a transition period - which undoubtedly has to be granted.
When it comes to funding costs for governments, a healthier banking system with better
diversification would pose less of a burden on states. The contingent liabilities of the
government would shrink which - all other things being equal - would reduce the risk of
investing in sovereigns and, eventually lower the sovereign bond yields.
The current regulation's assumption that government bonds are risk-free has been dismissed
by recent experience. The time is ripe to address the regulatory treatment of sovereign
exposures. Without it, I see no reliable way of breaking the sovereign-banking nexus.