The latest issue of European Economy examines the interactions between banks and sovereign risk, its building up during the crisis and the pros and cons of the policy proposals on the table to severe this loop and, more broadly, to finally complete the Banking Union. It shows how the merits of the regulatory reforms are strictly intertwined with the mechanisms of risk sharing being built up and implemented within the Banking Union and more broadly within the Eurozone. It is very unlikely that there might be viable solutions to the regulatory treatment of Sovereign exposures without a strengthening of these risk-sharing mechanisms.
A crucial aspect to be considered is that the nature of the loops and interconnections between banks and sovereigns that emerged after the 2007-2008 financial crisis are very different in countries with their own central banks and currencies and in countries that belong to a monetary union, like the Eurozone. This distinction is crucial and also helps us analysing both the building up of the perverse loop at the inception of the crisis and possible solutions in ‘normal times’.
Inception of the crisis and lack of risk sharing
Besides, of course, from the primordial vice of excessive deficit and debts in some of the vulnerable countries and of ailing banks following Lehman, the inability of the Eurosystem to act swiftly and thoroughly as a lender of last resort and the lack of a Banking Union and of an effective mechanism of fiscal support among member states were key ingredients in the building up of the vicious circle at the inception of the crisis. The loop was indeed diabolic, as many labelled it (see the high correlation between the yields of banks’ and sovereigns’ CDS in Figure 1), but probably it was unavoidable in that institutional setting. The decision by banks to invest massively in their home sovereigns was to a large extent rational, and in many circumstances they had no alternatives. And bank purchases of sovereign debt probably smoothed the worse downfalls at the peak of the crisis.
Figure 1 Ten-year CDSs on sovereigns (LHS) and five-year CDSs on banks (RHS)
Source: Thomsom Reuters Datastream. For banks, Data refer to averages of five-year credit default swaps on banks from each country. Data are expressed in basis points.
Taming the crisis: Risk-sharing mechanisms, lender of last resort and the banking union
Yet this was an untenable equilibrium in the longer term: frail banks supporting frail sovereigns and back. Eventually, the perverse spiral of the crisis was tamed through the implementation of risk-sharing mechanisms (the EFSF, the ESM, the sequence of interventions in support of Greece), the activation of lender of last resort interventions by the ECB (the large Long-Term Refinancing Operations, LTRO, in December 2011 and February 2012) and the announcement of a buyer of last resort programme (the Outright Monetary Transactions program, OMT, implicitly announced with Mario Draghi’s “whatever it takes” speech in July of 2012). In other words, only when some essential tools for managing collectively systemic crises at the the level of the EU, and especially within the monetary union of the Eurozone were finally put in place. This is reflected in the decline in CDS yields thereafter (Figure 1)
Besides from the emergency safety nets and the aggressive monetary policy, the Banking Union itself was enacted to provide long-term solutions to sever the perverse loop. The combined action of two of the three pillars of the Banking Union, fully or partially implemented as yet – enhanced and centralised supervision and higher capital requirements; a resolution framework with bail-in procedures – do transfer effectively a large share of bank risks and of the costs of banks’ resolution from taxpayers to investors. The third pillar, the EDIS, whenever implemented, will introduce a risk-sharing mechanism among euro countries that partly reduces the direct link between national tax payers and national failing banks.
Yet, while necessary, these three pillars cover only one side of the loop – the risk that banks’ crises end up on the shoulders of home taxpayers – but not the other side – that too much exposure towards home sovereign bonds weakens banks’ balance sheets. The present regulatory framework in Europe, but also in the other OECD countries, still considers banks’ exposure towards domestic sovereign bonds as risk free and it grants very favourable provisions in terms of large exposure limits towards these assets. The crisis left much debris on the ground, and indeed it is not yet over. Banks’ exposures to sovereigns, and especially to home sovereigns, are still very high, as shown in Figure 2. So what should be done as times hopefully become normal?
Figure 2 Share of domestic sovereign bonds held by MFIs to total assets
Source: ECB. Ratio of the holdings of domestic sovereign debt and total assets by MFIs in each country. Data are expressed in percentage points.
As times become ‘normal’: How to deal with sovereigns’ risk asymmetries?
The debate is fierce. Several banks and governments in the more vulnerable European countries are extremely resistant to a tightening of the regulatory framework that would raise capital requirements and limit the size of sovereign exposures. Others in less vulnerable countries, and a large share of the academic and institutional community, argue instead that these steps are urgent and appropriate to enhance the financial stability of the EU. And hence the reluctance of risk-free countries to complete the Banking Union with the implementation of the EDIS, unless the issue of the asymmetric risk of sovereign exposures is somehow addressed.
In evaluating the different proposals, we must remember that while at the inception of the crisis the lack of risk-sharing mechanisms would have probably made more stringent regulations ineffective, if not harmful, for normal times this argument is reversed. It is precisely because of the implementation of mechanisms of risk sharing during the crisis, and of those envisaged by the institutional reforms enacted thereafter, that the issue of the treatment of different levels of riskiness of European sovereigns has to be addressed.
What, then, can be done? Simple regulatory solutions, like straightforwardly increasing capital requirements or imposing stringent large exposures limits, risk being disruptive in the short term and politically not viable. In broader terms, there are two sets of proposals on the table (for an assessment of potential measures, see European Systemic Risk Board 2015). The first, proposed by the German Council of Economic Experts (Andritzky et al. 2016, and in the latest issue of European Economy), is based on a principle of ‘horizontal discrimination’ between sovereign bonds, whereby risk weighting, large exposure provisions, or other regulatory measures should reflect the effective riskiness of member states, as measured by different rating mechanisms.
An alternative mechanism is instead based on a combination of ‘horizontal’ and ‘vertical’ discrimination (Brunnermeier et al. 2011, 2016, Corsetti et al. 2016). The paper by Marco Pagano in European Economy discusses this option. The idea is to introduce different regulatory treatments based on the riskiness of the sovereigns – in line with the proposal of the German Council of Economic Experts – but to create at the same time a risk free asset through pooling and tranching portfolios of sovereign bonds (‘vertical discrimination’).
There is no room to discuss the pros and cons of these proposals here, and we refer the reader to the pieces in European Economy and our editorial summarising the issue. In essence, we think that the combination between horizontal and vertical discrimination can be appealing for three reasons. First, it involves a mechanism of market-based risk sharing, because it creates a portfolio of sovereigns issued by all Eurozone member countries. Second, by introducing a ‘vertical’ risk discrimination among different tranches of the same diversified portfolio, it generates a large pool of low-risk assets (larger than otherwise), which are necessary to fulfil the needs of banks. Third, it reduces the risk of severe shortages in the demand of bonds in vulnerable countries, as might instead emerge under a pure horizontal mechanism.
Beware transition: Times must really be ‘normal’ and risk-sharing mechanisms fully loaded
One last issue to consider is transition. Reforming the regulation on banks’ sovereign expositions is not easy, and there are crucial costs in transition (and events like Brexit do not make the issue smoother) – since markets tend to frontload regulatory changes, even a slow path to a fully ‘horizontal’ risk discrimination could cause huge problems to banks and sovereigns. Increased risk weights might induce procyclical behaviour and jeopardise the already very slow recovery in lending. Limits to exposures, may generate large portfolios adjustments and large yields and prices gyrations in the Eurozone. As shown by Lanotte et al. in European Economy, the magnitude of these adjustments can be very sizeable.
So, whatever the directions of the reforms, times should really be ‘normal’ before implementing them. Action requires time, a very carefully designed transition, and ingenious institutional mechanisms. Moving forward, it could be very disruptive if clear steps to strengthen the framework for risk sharing within the Banking Union and among Eurozone countries are not undertaken at the same time.
Editors’ note: This column is derived from the editorial of the latest issue of European Economy, which examines the interactions between banks and sovereign risk, its building up during the crisis and the pros and cons of the policy proposals on the table to severe this loop and, more broadly, to finally complete the Banking Union.