Eurozone must lead search for doom-loop fix

Basel Committee working on sovereign risk, but eurozone has most at stake

If the financial system is the engine that powers the economy, then government bonds are the oil. Their importance has grown since the 2008 financial crisis. Sovereign bonds are counted as high-quality liquid assets in Basel III's liquidity coverage ratio, and are a key form of eligible collateral for derivatives trades that face increased clearing and margin requirements.

All of which makes the debate over how much capital banks should hold against their exposure to sovereign debt even more sensitive. Banks are understandably peeved at the idea that, after several years of new regulations requiring them to hold larger quantities of sovereign debt, they should now be hit with higher capital charges on those holdings. And it is, of course, a highly political issue to start with: government debt finances public spending.

The difficulty is also distinct to the eurozone. Theoretically, governments that issue debt in their own currency can avoid default by simply increasing the money supply – albeit at the cost of higher inflation. But in the absence of a single eurozone Treasury, the Eurogroup nations no longer have that option. As Greece discovered in 2012, this renders them vulnerable to default, just as emerging markets were in the 1980s and 1990s when their governments issued debt denominated in US dollars.

In July, the Council of the EU chose to pass the buck to the Basel Committee on Banking Supervision, which has promised to draft new rules on the prudential treatment of sovereign debt by late 2016 or early 2017. However, if the problem of sovereign risk is fairly specific to the currency union, then non-eurozone members of the Basel Committee may be unwilling to impose heavy costs on their own banking systems to solve it. In the US, for example, municipal bonds and paper issued by government-supported entities providing loan guarantees both form huge asset classes. There could also be implications in emerging markets to which European banks are exposed.

A mix of concentration limits and risk weights seems the best way to achieve rules that bite, without creating distortions between core and peripheral eurozone sovereigns

This makes it likely the onus for answering the question will remain inside the eurozone. The European Systemic Risk Board (ESRB), which includes EU central bank governors and representatives from the European Supervisory Agencies and the European Commission, is at the forefront of efforts to find an answer. What is evident is that any changes to prudential rules will need to be carefully calibrated. And they must be accompanied by changes in market structure to reduce the dependence of sovereign issuers on bank buyers.

A mix of concentration limits and risk weights seems the best way to achieve rules that bite, without creating distortions between core and peripheral eurozone sovereigns. Even now, smaller sovereigns are fretting about whether regulation is driving the exit of bank primary dealers, hitting local bond liquidity as a result. The ESRB is preparing a report on that related subject for publication in September this year.

Market structure changes could include modifying private and central bank collateral requirements to discourage banks from concentrating in their home sovereign debt, and building the institutional investor base in the most bank-dependent countries such as Spain.

However, the ESRB is also scrutinising zero risk weights on sovereign debt beyond the banking sector. Solvency II allows a similar treatment for insurance companies. The Banca d'Italia estimates Italian insurers held €280 billion in domestic sovereign debt in 2014. If regulators make insurers forced sellers alongside the banks, then retail and foreign investors would have to pick up the slack, crowding out investment to the private sector, staff at the Italian central bank warn.

Little wonder ESRB experts are beginning to think more radically. Specifically, they are seeking a way to allow EU financial institutions to hold the same quantum of sovereign debt without facing the same concentration or contagion risks. One suggestion is to securitise a pan-eurozone pool of sovereign bonds and allow banks to hold the senior tranche for their liquidity buffers and collateral management. The idea makes intellectual sense, but navigating the turbulent politics of both reviving securitisation and any perceived mutualisation of sovereign risk will be a tall order.