Bank holdings: Keep banks in the loop

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The sovereign-bank nexus or the doom loop? Whatever you like to call it, senior German and European policymakers are wrong to want to limit bank holdings of government debt.

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European Union finance ministers are looking at restricting holdings by banks within the bloc of bonds issued by their own governments, either through outright exposure limits or via the removal of zero risk weightings on sovereign debt.

Those in favour of the move argue it is vital to prevent contagion between banks and sovereigns. Opponents – including the governments of Italy, Poland, Hungary and Malta – say it will destabilize banking sectors and raise needless barriers to states’ ability to fund themselves.

Who is right? To answer that question, it is necessary to ask three others. Would the links between banks and sovereigns be reduced by restricting bank buying of sovereign bonds? Are they really as dangerous as the doom mongers suggest? Would the costs of such a move be justified by the effects?

In all three cases, the answer must surely be no. Starting with the infamous doom loop itself, it is hard to see how this could be broken by changing the risk weighting on government bonds. 

Clearly, the hope is that limiting banks’ sovereign bond holdings would enable countries to default without triggering a simultaneous banking crisis. This, however, is wishful thinking. If a country defaults, its banks are never going to come off unscathed.

Argument

There is an argument for preventing banks loading up on local government debt once it becomes apparent that a sovereign default is imminent. At least within the eurozone, however, this is easily achievable without sweeping changes to government funding structures. The European Central Bank can limit individual bank exposures and, as a supranational body, should be immune to local political pressure. 

In non-crisis situations, meanwhile, bank buying of sovereign debt is often hugely beneficial to both parties. For banks, local government bonds are exactly the type of high-quality liquid assets that European authorities have been pressuring them to hold. For governments, stable domestic debt financing is clearly preferable to potentially volatile foreign flows. 

German policymakers, who are pushing for the restrictions, apparently fret that having a strong local investor base encourages countries to run up debt. The success of numerous dicey sovereigns in selling dollar bonds to international investors, however, clearly makes a nonsense of this argument.

What could prompt sovereign debt crises, however, is forcing banks – particularly in highly indebted countries such as Italy – to sell down their government bond holdings. 

It is understandable that European policymakers want to enhance banks’ resilience – however, ample measures have already been taken to achieve this. CRD IV, BRRD, AQR, SSM, ESM, SRM – a whole alphabet soup of initiatives has already stuffed the continents’ banks with capital and liquidity over the past five years, while work on resolution regimes is proceeding apace. 

There is simply no need to add yet another layer of regulation, particularly one that could raise funding costs for countries already buckling under high debt burdens.