Germanys Bundesbank is not afraid of playing the role of bad fairy. Last year it opposed the European Central Banks scheme for buying potentially unlimited quantities of sovereign bondsa promise which ended the hot phase of the euro crisis. Last week, it criticised rules that encourage eurozone banks to load up on their own governments debts.
Jens Weidmann, the Bundesbank president, is right to put this topic on the agenda. After all, the exposure of banks to governments is one half of what has been dubbed the sovereign-bank doom loop. When governments such as Greece got into trouble, they dragged their banks down as well. (The other half of the doom loop involves troubled banks dragging down their governments.)
The problem is how to break this loop without triggering a new crisis in vulnerable countries such as Italy and Spain. After all, if their banks were suddenly told to cut their holdings of Italian and Spanish bonds, Rome and Madrid would be hard-pressed to fund themselves.
Weidmann mentioned two rules that encourage banks to load up on government debt in an article in the Financial Times.
First, banks holdings of sovereign debt are exempt from the so-called large exposures regime. This says banks are not allowed to lend more than a quarter of their eligible capital to any single counterparty. The basic principle is lenders are less likely to get into trouble if they dont have too many eggs in one basket.
Second, banks normally have to set aside a slice of capital against any loan they make as a buffer in case it goes bad. But their sovereign exposures have low or zero capital requirements.
Both these regulatory privileges, which are standard practice around the world, are justified by the idea that sovereign debt is risk-free. Whatever one thinks about this notion in other parts of the world, it is clearly not the case in the eurozone as individual governments there cannot print money to get out of a debt crisis. Whats more, the debt of some governments such as Greeces is clearly riskier than the debt of others.
This regulatory favouritism meant banks loaded up with sovereign debt before the crisis. In Italy and Spain, they also increased their exposure during the crisis. Foreign bondholders fled from the periphery, meaning the domestic banks had to take up the slack.
The ECB helped this process by giving banks unlimited supplies of cheap long-term loans two years ago.