Memo to Regulators: Sovereign Debt Can Be Risky

What could possibly go wrong?

Photographer: Xaume Olleros/Bloomberg

Five years after a sovereign-debt crisis almost destroyed the euro, Europe's leaders have yet to address a crucial vulnerability: the threat to banks posed by losses on sovereign bonds. Finance ministers are planning to discuss the question on Friday. An answer is overdue.

Governments have been going bust for centuries. Argentina, Russia and Greece recently reminded borrowers, in case memories needed refreshing, that sovereign bonds aren't always safe. Yet European regulators treat government bonds as risk-free when assessing the financial strength of banks. For the purpose of figuring out whether banks have enough capital to absorb potential losses, they often place zero weight on investments in sovereign debt.

Naturally, therefore, banks buy a lot. That's great news for a government like Italy's, which sells more bonds than any other in Europe and relies on domestic banks to fund more than 90 percent of its total borrowing of 455 billion euros ($514 billion). No wonder Italian Finance Minister Pier Carlo Padoan says his government is "strongly against" any curbs on debt holdings.

Having a pool of local buyers makes government borrowing easier and helps keep interest rates down, but it can worsen systemic risk. When a government's creditworthiness begins to be questioned, banks holding its debt will be dragged down too. With government debt accounting for 10.5 percent of bank assets, more than double the euro zone average, Italy's financial system is too fragile.

It doesn't help that the European debate on sovereign risk is entangled in a wider discussion about protecting depositors if a bank in the euro zone fails. The European Commission has proposed a mandatory system-wide deposit-insurance program, but Germany is unwilling to pay for other countries' mistakes and wants the bloc's banks to be less exposed to sovereign risks before it signs up.

Euro-zone deposit insurance is needed, but Germany's reservations aren't unreasonable -- especially when Europe's rules fail to recognize that some government debt is safer than others. Trouble is, making those distinctions isn't always easy.

The financial crisis undermined the credibility of the rating agencies. A better guide to creditworthiness will have to be derived from market measures such as bond yields or the credit-default swaps investors use to insure against default. (Investors currently charge Greece about 8.7 percent to borrow for a decade, compared with less than 0.2 percent for Germany and 1.4 percent for Italy.) In addition, the principle of safety first should apply.

Whatever the exact formula, requiring banks to recognize that the government debt on their balance sheets is not risk-free is necessary. Making them raise extra capital against their ownership of such debt would discourage over-borrowing by governments and make the banks more resilient. In the cases where this additional discipline was most needed, it would stop governments stuffing local institutions with sovereign securities and make them work harder to find a broader pool of buyers for their bonds. That can't happen too soon.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.