A bond that makes a bad marriage

How big is the financial threat looming over the citizens in the eurozone? There are two answers to this question: one short and bright, the other longer and gloomier.

Cheap and cheerful

On the cheerful side, Mario Draghi, president of the European Central Bank (ECB) succeeded in freeing the crisis countries from exorbitant borrowing costs when he announced a new bond-buying scheme. The program, which allows for unlimited ECB purchases of government bonds on the secondary market, helped to hold interest rates on eurozone sovereign bonds in check. Thanks to Draghi’s intervention, governments in Greece, Italy, or Spain now have cheaper access to money and hence a more realistic chance of receiving funding and eventually repaying their debt.

However, there is also a longer and more pessimistic account of the current situation. To highlight some of the shortcomings we need to ask ourselves: are states and their taxpayers adequately protected against future crises in the financial markets? And does the financial system establish an adequate relationship between property and liability? Unfortunately, the answer in both cases is “not yet.” The main problem stems from excessive interdependence between states and banks, as becomes apparent from the balance sheets of major banks.

Bail in or bail out

Let’s start with their liabilities. There have been some reform efforts, such as, Germany’s national restructuring law (the Restrukturierungsgesetz) that came into force in 2011. Yet in most cases losses that result from bank failures are still not imposed on creditors.

An OECD study (Developments in the value of implicit guarantees for bank debt, 2012) shows how rarely bank debt holders incur such losses. The survey found that out of 21 mature economies there were only four (Denmark, Iceland, the United Kingdom, and the United States) where creditors experienced losses in more than one case of bank failure. But if creditors don’t help bailout troubled banks, then someone else has to foot the bill: national governments and their taxpayers.

However, this leads to a vicious circle. Banks whose businesses go sour receive funding from their national states. Thereby those states strain their budgets and worsen the conditions for their government bonds. In turn, however, degenerating sovereign bonds damage the banks that hold these very assets, necessitating further state support.

The name’s bonds, risky bonds

How exposed are banks to such a threat? That depends on their assets and in particular the extent to which they hold sovereign bonds. This debt taken out by governments used to be considered risk-free.

Even before the euro crisis, this assumption was questionable. It neglected the fact that numerous countries had previously defaulted on their debt and failed or refused to repay their creditors. It also overlooked that different countries have always had to pay different interest rates; this so-called ‘credit spread’ between countries like Germany and Greece represents the varying risk of default. Finally, the assumption of risk-free government bonds falsely assumed that their owners could always sell them at will.

In the current crisis, this assumption has become untenable. Various country reports from rating agencies testify to this. Nevertheless, the results of the European stress tests for banks in December 2011 show to what degree banks still rely on sovereign bonds: Greek banks invested 400 percent of their equity in bonds issued by their own government. In Portugal, this ratio was 300 percent and in Spain and Italy 150 percent.

Why do banks invest so excessively in increasingly risky assets? One reason is there are at least two distorting regulatory incentives. First, banks that invest in government bonds don’t have to back them up with equity; second, there is no limit for such investments.

Even in Basel III, the most recent global regulatory standard on bank capital adequacy, those two elements of Articles 109/145 of the Capital Requirement Regulation have not been changed. Instead, banks are going to be required to reach a certain “Liquidity Coverage Ratio” with a high percentage of secure and liquid assets. Government bonds fall prominently under this category even though they can be more risky and illiquid than corporate bonds.

Set the taxpayers free

In conclusion, two sets of rules are necessary to stabilize the financial sector and re-establish a healthy relationship between risk and return. First, concerning banks’ liabilities, the cost of bank failures should be imposed first and foremost on their creditors. Provisions to that effect such as the EU Recovery and Resolution Directive (ERD) go in the right direction. But the envisaged bail-in clause should be enacted now rather than in 2018 as currently planned.

Second, on the asset side, banks’ investments in government bonds should both be capped and discouraged by abolishing distorting incentives in Basel III. Only then can taxpayers and their governments be alleviated from unnecessary risks and start leaving the financial crisis behind them.