Editor's Note: Daniel Gros is Director of the Center for European Policy Studies. For more from Gross, visit Project Syndicate or follow it on Facebook and Twitter.
By Daniel Gros
Greece’s ballooning public debt is again throwing Europe’s financial markets into turmoil. But why should a debt default by the government of a small, peripheral economy – one which accounts for less than 3% of eurozone GDP – be so significant?
The answer is simple: the financial system’s entire regulatory framework was built on the assumption that government debt is risk-free. Any sovereign default in Europe would shatter this cornerstone of financial regulation, and thus would have profound consequences.
This is particularly visible in the banking sector. Internationally agreed rules stipulate that banks must create capital reserves commensurate to the risks that they take when they invest depositors’ savings. But when banks lend to their own government, or hold its bonds, they are not required to create any additional reserves, because it is assumed that government debt is risk-free. After all, a government can always pay in its own currency.
This assumption makes sense, however, only when a government issues debt in its own currency; only then can it order its central bank to print enough money to pay its creditors. Before the introduction of the euro, this was the case in all advanced countries.
But the countries that adopted the euro can no longer rely on the printing press. They are, instead, effectively borrowing in a “foreign” currency (or, rather, a currency that they cannot individually control). It should thus have been clear that with the start of European Monetary Union (EMU), participating countries’ public debt should no longer have been considered risk-free.
But it was. Indeed, eurozone regulators not only maintained the assumption that the public debt of a bank’s own country was risk-free, but chose to extend it to all eurozone countries, implying that banks did not have to provide additional capital against their holdings of any eurozone public debt. This is the key reason why one-third of all public debt in the European Union is held by banks. And this concentration of public debt on banks’ balance sheets is what makes the entire European banking system so vulnerable to a sovereign default.
Moreover, given the prevailing assumption that public debt was risk-free, banks were not bound by the usual rules against “large exposures”: they could accumulate as much exposure to any one government as they wanted. That is why Greek banks could end up holding more government debt than they have capital. A government default would thus wipe out the entire Greek banking system.
It is now too late to turn back the clock and suddenly force banks to get rid of their excessive holdings of public debt. Unfortunately, regulators do not even appear to be learning from the current crisis in order to prevent the next one.
The EU’s rules on how much capital banks must hold are about to be revised. The rules, which are detailed in a 500-page legal proposal, called “CRDIV” and published recently by the European Commission, will increase the amount of capital banks must hold, but only for lending to the private sector. Lending to eurozone governments continues to have a zero risk weight. This will only increase the bias in bank lending towards government debt and against lending to enterprises, especially small and medium-size businesses.
This is a mistake. The European Commission should have introduced capital requirements on banks’ holdings of public debt. The justification would be simple: no one can seriously claim that the bonds of all eurozone governments are without risk. It should thus be obvious that banks should hold some capital against the risks they assume when lending to governments with particularly high debts or large budget deficits.
Moreover, the new rules will require banks to hold more liquid assets. It is easy to guess which assets the authorities consider liquid: public debt. In this way, too, banks will be induced to hold public debt rather than to finance private investment, despite the obvious fact that government bonds can become very illiquid (for example, those issued by Greece, Ireland, and Portugal). The definition of what banks should hold for liquidity purposes should have been broadened beyond public debt to include a wide range of private-sector assets based on market size.
Both key elements of the new banking rules thus go in the same direction: they increase the bias in bank financing against lending to the private sector.
It is easy to understand why the authorities persist in favoring public debt: the rules are set by finance ministers, who are naturally inclined to give themselves a good deal. Moreover, it is difficult for politicians to see that their budgets compete for a limited pool of savings. Lower financing costs for public debt appear to be a net gain to society, because the government then saves on debt service and can keep taxes lower. But any gains from lower taxes are more than offset by the losses to the private sector, which, facing higher financing costs, will invest less, in turn lowering economic growth – and thus reducing government revenues.
Many steps have been taken in recent years to reinforce regulation of the banking system. But what is proposed now will make lending for investment even less attractive and increase the incentive to concentrate sovereign risk in the banking sector. This can only worsen Europe’s sovereign-debt problem and weaken its already meager growth prospects.
The views expressed in this article are solely those of Daniel Gross. Copyright: Project Syndicate, 2011. For a podcast of this commentary in English, click here.
All of these European countries are in the tank. The government of these countries wanted socilization and no country survives in the long run with that. We are headed that way as our government at the moment was it also. Free everything. Welfare, free education, subsudise rent, food stamps, loans to buy houses people cannot afford ( well maybe they could come up with a down payment but can't afford to pay for all the rest that goes with it) credit cards driver licenses, social security when they haven't worked, healthcare and all this for the Illegals coming in here. Our own people with a job cannot hardly pay for this stuff. Socialization will put us in the tank with the restof the world also. If you honestly want that then vote for the same ole same ole.
Lets be honest. US is Exhibit A in a world debt. We should stop lying to ourselves. We are like Greece, only times 20. Our press is rolling fast. By the way, I am sorry for folks who blame Obama for this. They don't understand much. This is, as if to blame surgeons for inflicting pain upon the patient who was shot. I blame the one who pulled the trigger of deregulation.
How much longer can you hold a system bases in unjustice?
This was a very enlightening article. I did not know about the capital requirements of public vs private debt that the banks must follow. Thanks for the information.
Greeks have done nothing except enjoy the fruit of several other countries over the last 4 decades. Bailout is never a solution.. a fall out is the best way for Greeks to learn a lesson and get their lazy a** to work............
Greeks have done nothing except enjoy the fruit of several other countries over the last 4 decades. Bailout is never a solution for them.. It is now time for a fall out in Greece. This is the best way for Greeks to learn a lesson and get their lazy a** to work............
The lesson learned is don't run up the national debt at a time when American Banks are in the process of destroying the world's economy. The banks lost money but the bankers made a LOT of money at our expense.
Eventually several European countries incl. Spain, Iceland, Belgium will be headed this way................And those who don't, including Netherlands, UK, France, Germany, Russia, Norway, Sweden, Denmark will see them inching joining the ranks of the less affluent countries like S.Korea, Taiwan, Thailand....THANKS TO HORDES OF UN-EDUCATED, "WELFARE IMMIGRANTS" FROM THE MUSLIM COUNTRIES!!!! Eventually with Europe embracing Muslim TURKEY, KOSOVO, BOSNIA into the EU, Europe's ISLAMIZATION WILL BE COMPLETE. Already in the UK, the MOST COMMON LAST NAME of children born is MOHAMMED, and the UK Muslim population is galloping at MORE THAN 10 TIMES THE NATIONAL AVERAGE (that includes all other minorities incl. Hindus, Sikhs, Jews etc.), while the POPULATION OF ETHNIC WHITE CHRISTIANS IS ACTUALLY FALLING!!!!
SO THE DEMISE OF EUROPE AS IT EXISTS TODAY IS WELL ON ITS WAY, which will eventually impact America also…..thanks to VALIANT EFFORTS by FAREED ZAKARIA. Dean ObeidALLAH and others in opening the doors for GREATER & GREATER MUSLIM IMMIGRATION INTO AMERICA.
Check these out:
MUSLIM MAJORITY IN EUROPE – Interview of leading ISLAMIC BROTHERHOOD PREACHER IN Egyptian TV
How even MUSLIMS ACCUSED OF TERROR are (mis) using Europe’s lax Immigration laws into gaining citizenship!
YouTube-MOST SCIENTIFIC ANALYSIS of MUSLIM DEMOGRAPHICS –by NewAmerica Foundation-GREATEST
Income& Educational achievements of AMERICAN MUSLIMS (the most progressive Muslim community). They lag behind Hindus, Jes by a ratio of 5 to 1. And ethnic whites by a factor 2 to 1…….PEW Research:
ISLAM ON THE OUTSKIRTS OF THE WELFARE STATE
The the prospect of a default by tiny Greece having such an effect on world financial markets, how can U.S. politicians be seriously considering staging a default by the United States just for the sake of political grandstanding. Can you imagine how the world's economies would be roiled if that were to happen? Some of these would-be grandstanding politicians say that it would be okay because it would not be an "immediate" disaster. But it would be a disaster nonetheless, even if it took several months to a year for it to unwind. Is the right wing trying to stage a worldwide depression in order to win the 2012 U.S. president campaign? (That's what it sounds like.)
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