Breaking the vicious circle

This op-ed was originally published in the October / November issue of Financial World.

The eurozone’s banking union has moved from vision to reality in a short period of time, with the European Central Bank now an established supervisory authority for the area’s large banks. This has already made a big difference to the many national banking champions that local supervisors had been treating with kid gloves. But the banking union’s ultimate policy goal, memorably defined by heads of state and government in June 2012 as the “imperative to break the vicious circle between banks and sovereigns,” has not yet been achieved.

One essential link in this vicious circle is the vast inventories of domestic sovereign debt held by many European banks. Reducing these holdings is now central to discussions on a more complete banking union.

The Dutch EU presidency in the first half of 2016 valiantly tried to make progress but could not overcome the stalemate of entrenched positions. Most countries want to keep the option of using national banking systems as buyers of last resort of their sovereign debt.

In May, the Governor of the Bank of Italy referred publicly to the need to maintain “banks’ ability to act as shock absorbers in the event of sovereign stress.” Even Germany, usually an advocate of strict fiscal discipline, is constrained by the role played by its local banks (the Landesbanken) in financing public-sector activities at local or regional level. But, at the same time, the German government refuses to endorse the creation of a European deposit insurance scheme (EDIS), a cornerstone in banking union, unless limits are put on banks’ domestic sovereign exposures. Its concern, not unreasonably, is that the risk-sharing inherent to EDIS could be exploited by impecunious governments. The fear is that EDIS could be used to get easier government financing conditions through outright financial repression or through the use of “moral suasion” on domestic banks.

The Ecofin meeting of finance ministers and central bank governors in mid-June decided that any new initiatives on the regulatory treatment of sovereign exposures will await the outcome of ongoing work at the Basel Committee. It is only then that EDIS be discussed “at the political level.”

But the issue of sovereign exposures cannot be simply wished away. To achieve resilience, the eurozone needs to enable banks to withstand sovereign stress, even in their respective countries of origin. Only then can the banking system act as a genuine shock absorber for the local economy – as happened, say, in the Baltic countries in 2009-10 when local banks were supported by their Scandinavian parents. Forceful regulatory measures are needed to sharply reduce home bias in banks’ sovereign debt portfolios and to ensure that it do not reappear.

This is a specific eurozone challenge that calls for a specific eurozone solution. In countries that have their own currency, including those inside the EU, the bank-sovereign linkages are less “vicious” since the central bank can act as a buyer of last resort of sovereign debt. Outsourcing the problem to the Basel Committee, therefore, will almost certainly bring no breakthrough. Conversely, the eurozone can strongly limit the home bias, without practically constraining the banks’ total holdings of euro-denominated sovereign bonds as “safe assets,” since these can be diversified across 19 issuing countries and there would be no adverse competitive distortion with banks from outside the eurozone. This could be done with a graduated capital charge on any individual eurozone government’s debt.

Holdings at banks of such debt under, say, 25 or 50 percent of own funds could face a limited capital charge, which is gradually increased once the threshold is crossed. That would vastly improve the banks’ incentives to avoid the current home bias. Such thresholds should not depend on a sovereign’s perceived riskiness but be applied to all Eurozone banks and member states in the same way. The inescapable reality is that there is no objective way of assigning any significant issuer-specific risk weights to sovereign countries and any attempt to do so may be damaging.

National debt management offices can be expected to lobby fiercely against limits on eurozone banks’ sovereign exposures, but financial stability demands such limits. Together with provisions for bailing-in the creditors of unviable banks, which are now in place, if not much tested in practice, sovereign exposure limits would avert the sort of contagion spiral that nearly broke up the eurozone in 2011-12. They would also bring some welcome fiscal discipline to member states – a good thing given the otherwise toothless eurozone fiscal framework. Several EU countries already exhibit low home bias in their banks’ debt portfolios, for example Finland, the Netherlands and Sweden. With adequate transitional arrangements, it can be done.

The Eurozone should aim for a package to strengthen banking union, including the introduction of sovereign exposure limits, the implementation of EDIS broadly as proposed by the European Commission last November, and additional harmonisation of relevant features of bank insolvency regimes, such as the hierarchy of liabilities. Given lingering banking weakness in Italy, forthcoming elections in Germany and elsewhere, the distractions of Brexit and the sheer complexity of the issues, this negotiation is unlikely to be concluded immediately – but the sooner it is conducted, the better.