September 22, 2023

News Analysis: Is Greek Debt Risk-Free? European Banking Officials Think So

Despite the threat to the banking system caused by Greece and huge markdowns on Greek bonds in the market, European banking regulations maintain the fiction that Greek debt is risk-free. The same holds true for bonds from Ireland, Portugal or any other European Union country.

The regulations, left intact by new European Commission bank rules issued Wednesday, provide a strong financial incentive for banks to buy government debt. Because the risk of losses is officially zero, banks do not need to set aside additional reserves when they buy government debt. That effectively lowers the price.

“The assumption was that states don’t go bankrupt, which is obviously not true,” said Bert van Roosebeke, a banking expert at the Center for European Policy in Freiburg, Germany. “It’s totally crazy.”

Governments have benefited from the regulations, which helped to create a market for their bonds and keep interest rates low.

But now that Greece’s problems are shaking the euro area, the policy is being questioned.

Banks’ extensive holdings of sovereign debt are a central issue in the crisis, creating a dangerous link between government fiscal problems and bank stability. The exposure of financial institutions to government bonds adds another layer of complexity as European leaders struggle to find a way to reduce Greece’s debt load without bringing down the euro.

“The fact that private banks own considerable shares in European government bonds and risk a major share of their equity in this market makes a restructuring more difficult than otherwise,” Kai A. Konrad, an expert in tax law at the Max Planck Institute, wrote in a paper co-written with Holger Zschäpitz, a reporter for the newspaper Die Welt.

Regulators’ favorable treatment of sovereign debt “is like a subsidy by which the governments distort banking decisions, making banks more inclined to finance government debt than engage in their core business,” Mr. Konrad and Mr. Zschäpitz wrote in the article, published by the Ifo Institute for Economic Research in Munich.

Bank stress tests last week provided detailed information on European bank holdings of government debt and allowed analysts to estimate the potential carnage from a Greek default, as well as from price declines for other bonds.

The damage would be substantial.

The data indicated that most banks outside of Greece would survive if forced to recognize market losses on their sovereign holdings. But a large number would have to raise billions in additional capital to return to health.

For example, analysts at Credit Suisse looked at 49 major banks and posited what would happen if they absorbed markdowns on their Greek, Portuguese, Irish, Italian and Spanish debt in line with the losses those bonds have already suffered in the markets. That included a 50 percent markdown on Greek debt.

While only a handful of banks would fail, almost all of them in Greece, more than half the banks would need to raise new capital to bring their reserves back to levels considered healthy, Credit Suisse concluded. The total amount of money they would have to raise would be 82 billion euros ($116 billion).

While it would be easy to blame the banks for making themselves so vulnerable, they were responding to government incentives that are not likely to change anytime soon.

The new banking rules issued by the European Commission will sharply increase the amount of reserve capital that banks must keep on hand, in line with guidelines agreed to by the Group of 20 nations. But European government bonds will continue to be considered risk-free and immune to capital requirements, at least until 2015.

In explanatory documents released Wednesday, the commission acknowledged the issue, asking, “Isn’t the risk of such debt amply illustrated by current events in the euro area?” The commission went on to say that it was simply complying with an agreement among European leaders.

International banking guidelines also put a zero-risk label on government bonds bought by banks in that country. As a result, most banks have huge holdings of their own government’s debt. The five largest Italian banks, for example, own 164 billion euros in Italian government debt, making them acutely sensitive to the fiscal fortunes of their homeland.

New rules taking effect in the course of the decade will force banks to set aside at least minimal sums to cover the risk of government bonds. The so-called Basel III banking rules approved by the G-20 last year would require banks to hold capital reserves equal to at least 3 percent of all their holdings, regardless of the perceived risk. That rule, intended to prevent banks from taking on too much leverage or gaming banking regulations, would also apply to government bonds.

But the rule, known as a leverage ratio, would not take effect until 2018 and could still change. The European Commission said it would impose a similar rule by 2018, but it is waiting until after an evaluation period to determine whether the leverage ratio should be 3 percent or some other number.

The new European rule also gives the commission the power to impose additional capital requirements on banks, including their government bond holdings, if officials see a risk to the financial system.

“It’s not an option to continue like we are today,” said Mr. van Roosebeke of the Center for European Policy.

“The question is if politicians have enough courage to look at the risk.”

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