Banks can treat most government paper as risk-free. For euro zone members, that is plain dishonest, since countries which can’t print their own money can default.
Jens Weidmann, the president of Germany’s Bundesbank, has the right idea. A Financial Times column on Sept. 30 restated his long-held belief that European regulators should require banks to set aside capital against possible losses on loans to euro zone governments. As it stands, European exemptions mean sovereign debt from Spain or Italy can have the same “zero” risk weighting as bonds from Germany. In addition, government debt is exempt from the limits of exposure to a single counterparty.
The rules encourage banks to load up on debt from the weakest sovereigns, which lets those governments spend beyond their means. The risk of overspending is universal, but most of them can introduce enough inflation to keep away nominal default. Euro zone members do not have that escape route.
But the more euro zone debt banks hold, the more damage any government default will do to their balance sheets – and the greater the temptation will be for a euro zone bailout of troubled states and banks. It is an unsatisfactory arrangement.
Euro zone authorities don’t know what to do. In 2010, Germany pushed to make sovereign defaults orderly, and in 2011 regulators unsuccessfully tried to force banks to include sovereign exposures in their stress tests. Since 2012, the authorities have pretty much given up. Euro zone banks increased government bond holdings by 25 per cent to nearly €1.8-trillion ($2.5-trillion). Mario Draghi, president of the European Central Bank, promised to buy bonds if necessary. Banks did the ECB’s work for him.
Mr. Weidmann proposes a transition period to economically-sound risk weighting, but even this would cause long-term yields to rise sharply right away. That would push up governments’ borrowing costs, and blow a hole in some bank’s balance sheets, hurting lending.
Those consequences could be managed if the central bank offered plenty of long-term ultra-cheap funds to smooth lending, and began controlled and limited purchases of bonds issued by solvent governments. In other words, Mr. Weidmann should put his money where his mouth is.