In the last few weeks, the central banks of the globe finished their negotiations on the new rules for bank capital. They signed this Basel III agreement which was promised to be a landmark deal to increase the safety and strength of banks around the world.
It took them years to agree to this updated system. What do they have to show for it? There are some provisions that will improve the banking systems’ capital. In this respect, the agreement does represent a step in the right direction.
Unfortunately for everyone though, the central banks left some critical unfinished business that threatens the system still. One of the most dangerous of these is the way that they allow banks to deal with sovereign bonds on their balance sheets.
The threat surrounds those banks that maintain substantial and highly concentrated holdings of their own nation’s government bonds. These banks are a peril for financial stability around the world.
The problem centers on the way that the various national bank regulators opt to value their government bonds which are issued in local currency. They are permitted to regard these as entirely safe, so naturally they always will. It permits the members of the Basel Committee to weight the risk of their bonds at absolute zero.
The end result is that the banks are enabled (and encouraged) to take on huge holdings of their own country’s sovereign bonds and not have to hold additional capital for this. This means that there are a number of banking systems that function like massive creditors for their respective national governments.
The Bank of International Settlements has done a study on this. In nations including Japan and Spain, over ten percent of the various banks’ holdings are allocated to their government’s debt. In other nations such as Italy, this figure nearly doubles to almost 20 percent.
The danger is real. Should investors decide to sell these government bonds, the bank losses in these countries could be staggering. As recently as 2012 such a sovereign debt crisis erupted in Europe. It forces governments to jump in to rescue the banks.
To do so, they have to float still more debt, which causes bond portfolio values to plunge still further when the credit of the government becomes questionable. In economics, this is known as a “doom loop.” It has the capacity to catapult a banking panic into a full blown government and financial crisis. This graphic illustrates the loop:
Is Your Retirement Portfolio Protected from the Doom Loop of Sovereign Bonds?
Such fiscal crises have happened in the last decade. Thanks to the Basel Committee failing to act to prevent the root of the problem, they will happen again. It is not an easy problem to fix either. If central banks were to now mandate an immediate change in the rules, this would result in banks all selling off their government bond portfolios at once. This also leads to another sovereign debt crisis. There is no easy fix for this, so the Basel Committee just decided to not address the systemic danger and hope for the best.
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