The sovereign-debt doom loop still threatens banks

The world's central banks recently signed off on the Basel III rules for bank capital. The new system, years in the making, is a step forward: It will make banks stronger and safer. But there are several loose ends. One of the most important concerns the treatment of sovereign bonds on banks' balance sheets.

Banks that hold large, concentrated portfolios of their own governments' bonds can be a threat to financial stability. This practice needs to be discouraged. Unfortunately, the Basel Committee decided, for now, not to act.

National regulators can choose to treat government bonds denominated in domestic currency as safe -- and they do. All the committee members use this freedom to set the risk weight on such bonds at zero. This means their banks can load up on domestic sovereign bonds without needing to raise any more capital.

As a result, some banking systems serve as major creditors to their respective governments. According to a study by the Bank for International Settlements, government debt represents more than 10 percent of banks' assets in countries such as Spain and Japan. In

Italy, it's nearly 20 percent.

These holdings pose a danger. If investors turn against those bonds, they might inflict severe losses on the banks concerned. If governments then have to step in, issuing more debt to meet the cost, the value of the bond holdings might fall again as the governments' creditworthiness is called into question -- the so-called "doom loop" that can turn a banking upset into a fiscal and financial crisis.

Dealing with this requires care: A sudden regulatory change would force banks to sell their government bond holdings simultaneously, which might itself trigger a sovereign debt crisis. Also, some regulatory advantage for moderate holdings of domestic government debt isn't unreasonable. Banks may use sovereign bonds as collateral for managing liquidity, for instance, or act as marketmakers for such securities. Those functions should be preserved.

Bearing this in mind, regulators would be wise to set a nonzero risk weight for sovereign bonds from a single country that exceed some given threshold, linked to the amount of capital held by the bank. For instance, the BIS study imagines a scenario in which sovereign exposures worth up to 100 percent of required capital would maintain their zero risk-weight, while holdings over that limit would require more capital.

Such a regime would have to be phased in. The new rules could be limited to newly-issued bonds, which would help to avoid a sudden shock. But the regulators ought to move in this direction soon -- before the next sovereign debt crisis intervenes.

... Some regulatory advantage for moderate holdings of domestic government debt isn't unreasonable. Banks may use sovereign bonds as collateral for managing liquidity, for instance, or act as market-makers for such securities. Those functions should be preserved.