Banking: Europe’s battle to fix the ‘doom loop’
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Banking: Europe’s battle to fix the ‘doom loop’

Breaking the sovereign/bank nexus has been a priority for policymakers since the global financial crisis. The problem is particularly acute in Europe. One proposal, to end the preferential capital treatment for the sovereign exposures of banks, may presage a revolution in European capital markets. But getting Europe’s rival factions to agree on a policy is far from simple.

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In 49BC, Julius Caesar stood on the banks of the Rubicon with his most loyal veterans from the Gallic Wars. As he crossed the river onto Roman soil triggering a civil war, the historian Suetonius records he uttered the phrase “Alea iacta est” (The die is cast). March 9, 2012, marked an equally momentous point for Europe. The Greek debt default was the biggest in history, wiping €100 billion from its €350 billion of debts, and the first by a developed economy since 1948. 

The aftershocks from this financial earthquake are still being felt. The confident view of prominent European Commission member Joaquin Almunia at Davos in 2010: “In the euro area, the default does not exist,” was not just whistling in the dark; it was received wisdom. A central bank can print money and pay back government debts at par, making sovereign bonds risk-free in nominal terms. 

This special status is reflected in regulation. Under the current rules of the Basel Committee on Banking Supervision banks can give a zero risk-weight to: “Exposures to central governments and central banks denominated and funded in the domestic currency of that central government and central bank.” 

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