It's Official: Government Bonds Can Damage Your Wealth
For months, the European Union has been wrestling with the tricky issue of how much money banks should set aside to guard against losses on government bonds. The current rules maintain the myth that sovereign debt is zero risk-weighted; the system assumes that you'll always get repaid everything you've lent to a government, which flies in the face of centuries of sovereign defaults as well as the kerfuffle that's still not completely resolved in Greece. Now, one country has broken ranks.
Sweden's Financial Supervisory Authority has ordered its banks to come up with models that better reflect the reality that, yes, you can lose money on government debt. It also wants an acknowledgment that lending to one government -- Greece, for example -- might just possibly be riskier than lending to, say, Germany. No matter how obvious that might be to folk in the real world, the universe of banking regulation and capital standards can often remain trapped in a delusional Alice in Wonderland state long after logic has reasserted itself on market prices.
Former European Central Bank President Jean-Claude Trichet said one of his proudest achievements in the first years of the euro was the compression in European government yields. Borrowing costs dropped toward those enjoyed by Germany, the region's benchmark borrower, rather than rising to the levels of the bloc's less creditworthy nations. The Greek crisis, though, blew that harmonization apart. Ten-year borrowing costs range from 0.5 percent for Germany to 1.6 percent in Spain, 2.5 percent in Portugal and 7.7 percent in Greece; in the heady days of early 2005, investors charged Greece just 0.09 percentage point more than Germany for 10-year money.
Uldis Cerps, executive director of banking at the FSA in Stockholm, told Bloomberg's Frances Schwartzkopff that banks should be able to take account of how sovereign risk is priced every day in the bond market when assessing their capital bases:
The underlying idea, of course, is that you have some kind of differentiation. You clearly see the differences if you look at market pricing of sovereign debt.
The experience of Greek bondholders this year illustrates just how ridiculous the current situation concerning sovereign risk is:
When the Greek crisis reached its nadir in April, its benchmark debt was trading at about 47 cents on the euro. If the nation had gone bankrupt, investors faced losing more than half of the face value of their bonds. Moreover, those bonds were issued at the start of 2012 as part of the Greek program to impose losses on its lenders; holders handed in their old securities, and got back about 31.5 percent of what they were owed.
Even today, with Greece negotiating a new bailout program, the bonds are still trading at a discount of about 26 percent, suggesting the market isn't convinced they'll be repaid at full face value when they're scheduled to mature in February 2024.
In March, the European Systemic Risk Board, an agency of the ECB, published a report backing the argument for change, noting in particular that the more money banks allocate to government debt, the less they have to lend to companies. That same month, Bundesbank board member Andreas Dombret argued that "if banks were required to hold capital against the risks of their government bond portfolios, that would make them more resilient to fiscal distress," calling the need for reform "urgently necessary."
For governments, of course, having a captive audience of banks whose balance sheets are stuffed with their debt is a great way to ensure they can meet their borrowing needs month after month, year after year. So it's hard not to suspect that the EU is dragging its feet on acknowledging the reality of sovereign riskiness for as long as it can. Italy, in particular, relies heavily on its domestic financial institutions to buy its bonds, as the following chart of euro-zone government bond holdings shows:
Now that Sweden has dispelled the fantasy that government debt is risk-free, the rest of Europe should follow suit. Resolving the too-big-to-fail conundrum isn't just about how big strategically important financial institutions are; it's also about how to fairly gauge the risks on their balance sheets. If that diminishes their appetite for lending to their own governments, it's a price worth paying to make finance safer -- and more logical.
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