LUCREZIA REICHLIN

Lucrezia Reichlin, a former director of research at the ECB, is Professor of

Economics at the London Business School.

LUIS GARICANO
Luis Garicano is Professor of Economics and Strategy at the London School
of Economics.
JAN 27, 2014
Squaring the Eurozones
Vicious Circle
SALAMANCA The eurozone is caught in a diabolical loop, in
which weak banking systems harm their sovereigns fiscal
positions, which in turn compromise the banking systems
stability. But, over the last couple of years, policymakers have
focused largely on reducing banks impact on their sovereigns
for example, through a Europe-wide supervisory authority and
efforts to establish a European resolution mechanism while
ignoring the feedback in the other direction.
Although eurozone sovereign-debt markets have stabilized,
the share of sovereign bonds held by domestic banks has
increased sharply in the last few months, accounting for more
than half of the net increase in debt emissions in some countries.
In Spain and Italy, sovereign bonds now account for roughly
10% of banks total assets (see graphs below).
The risk is that any unexpected challenge faced by a weaker
debtor countrys sovereign-bond market say, Catalonias
secession referendum, or the renegotiation of the Portuguese
and Greek bailouts will undermine bank solvency, often even
more than in previous rounds of the feedback loop. Moreover,
even in the absence of a crisis, the sovereign-bond markets
geographical segmentation hampers monetary-policy
transmission substantially.
What accounts for banks growing bias toward their own
countrys sovereign debt? And what should be done about it?
The most obvious suspect is Basel III, the new global regulatory
standard for banks capital adequacy and liquidity. But, while
Basel III favors sovereign debt in general by assigning it a zero
risk-weight in calculating capital requirements, it does not favor
home-country debt, at least not within the context of the
eurozone. Indeed, Basel III treats all OECD government bonds
in the same way, regardless of whether they are denominated in
the issuing countrys own currency.
Likewise, while the European Central Banks collateral
policy imposes different haircuts on bondholders depending
on a countrys credit rating, it discriminates little between
countries. In short, current bank regulation neither encourages
nor discourages the home-country bias in banks sovereign-debt
holdings.
In fact, eurozone banks preference for home-country sovereign
bonds is rooted in a combination of factors, including fear of
redenomination a consequence of the crisis that leads banks to
concentrate their risk domestically and the expectation that
bailout mechanisms will be national. Given that the eurozone
lacks any supra-national fiscal backstop, such as a lender of last
resort or a debt-mutualization mechanism like Eurobonds, the
home-country bias can be expected to intensify whenever an
economy experiences a significant shock.
Against this background, European policymakers and regulators
must take action to encourage banks to diversify their sovereign-
debt holdings. Of course, a common fiscal backstop (along with a
single banking supervisor) would eliminate the bias. But there is
strong resistance to the fundamental changes to the eurozones
architecture that this would require.
A more feasible solution would be to introduce an explicit
regulatory bias against home-country sovereign-debt holdings.
This could be done in three ways.
The first option would be to place upper limits on the sovereign
debt held by banks for example, by eliminating the current
exemption of zero-risk sovereign bonds from regulators so-
called large exposure regime. But administrative caps are a blunt
instrument that introduce new nonlinearities and opportunities
for arbitrage and speculation. And weaker sovereigns,
legitimately fearing that such a scheme would suppress demand
for their debt, would almost certainly block it.
Another potential solution, proposed by the euro-nomics
group in 2011, would be to create European Safe-Bonds
(ESBies). A European debt agency would purchase eurozone
countries sovereign bonds, weighted according to each countrys
contribution to the eurozones GDP, and use them as collateral
to issue two securities. The first security, the ESBies, would be
composed of the senior tranche of the bond portfolio, and would
serve as the safe asset, while the second, risky security would
be sold to investors in the market.
ESBies would effectively fulfill the role of Eurobonds, but
without the joint and several liability that would demand treaty
changes. Though the lack of such debt mutualization has caused
weaker sovereigns to resist ESBies, while stronger sovereigns
contend that ESBies still demand excessive risk-sharing, this
solution could gain traction in the event of another crisis.
The third option would be to introduce a new rule conditioning
sovereign bonds zero-risk weight on banks willingness to hold
them in certain proportions for example, relative to GDP.
Although a transitional regime would be needed to avoid hurting
banks in weaker countries, such a rule would dramatically
reduce banks exposure to home-country sovereign debt. Indeed,
it could help to encourage the market-driven creation of a
eurozone safe asset a kind of non-regulatory ESBie.
Regardless of the approach, one thing is clear: European
policymakers and regulators must act now to eliminate the
negative feedback loop between sovereigns and their banks.
Waiting for another crisis to strike could have devastating
consequences for both.



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