One topic has brought Europe’s top finance officials together this year. Ironically, it’s the same topic that is tearing the continent’s finance system apart – the dangerous embrace between sovereigns and their domestic banks, in which states depend on the banks to buy their bonds, while the banks depend on the state to prop them up, with each weakening the other as a result.
In March, the European Union’s competition chief, Joaquin Almunia, said the region’s leaders were “not delivering” on pledges to fix the problem. In August, European Central Bank executive board member, Yves Mersch, warned that plans to break the feedback loop needed more work. And, in late September, Jens Weidmann, president of Germany’s Bundesbank, called for rules on sovereign exposures to be overhauled: “Without it, I see no reliable way of breaking the sovereign-banking nexus.”
Strong words – but Germany’s politicians appear not to have got the message. Although Weidmann’s argument focused primarily on risk-weights, sovereigns get an easier ride in other ways, too. As an example, Europe’s version of Basel III allows national supervisors to protect their banks from a rule change that would see volatility in government bond portfolios carried through to Tier I capital for the first time – and the German parliament’s finance committee is pressing the Bundesanstalt für Finanzdienstleistungsaufsicht (Bafin) to use that option.
“Regulators could avoid significant fluctuations of prudential capital for the institutions affected. The coalition parties would assume that Bafin will exercise this discretion,” reads a May report from the committee, and one of its members reiterates the call in Risk this month.
On the face of it, this reinforces the feedback loop that Weidmann and others are desperate to break – if bank capital is insulated from government bond volatility, but exposed to swings in other assets, it seems like a pretty good reason to continue loading up on sovereign debt.
Although Weidmann's argument focused primarily on risk-weights, sovereigns get an easier ride in other ways, too
The counter-argument might be that protecting regulatory capital ratios from sliding bond prices could actually help decouple bank and sovereign credit quality. But, then, banks are shielded from this volatility today – whether sliding prices translate directly into a capital hit or not, investors know what a weakening sovereign means for a bank that is holding a lot of its debt.
A better question is what the politicians hope to achieve. They say it’s about protecting banks from capital fluctuations – a point on which the Germans are united with the Italian members of the European Parliament who originally proposed the opt-out. But sceptics say it’s a matter of self-interest – capital volatility arising from government bonds will encourage banks to hold fewer government bonds, or shorter-dated ones at least.
And this explains why Europe has done such a poor job of breaking the feedback loop. Doing so would make it harder for some countries to finance themselves – even if only incrementally – and many of them are understandably loath to take that step.
The week in Risk.net, February 10-16 2017Receive this by email