Sovereign debt crisis: another Basel creature?

I often refer to the distortive effects of RWA on the housing and business/SME lending channels. What I don’t say that often is that Basel’s regulations have also other distortive effects, perhaps slightly less obvious at first sight.

Basel is highly likely to be partially responsible for sovereign states’ over-indebtedness, by artificially maintaining interest rates paid by governments below their ‘natural’ level.

How? Through one particular mechanism historically, that you probably start knowing quite well: risk-weighted assets (RWA). Basel 1 indeed applied a 0% risk-weight on OECD countries’ sovereign debt*, meaning banks could load up their balance sheet with such instruments without negatively impacting their regulatory capital ratios at all. Interest income earned on sovereign debt was thus almost ‘free’: banks were incentivised to accumulate them to maximise capital-efficiency and RoE.

This extra demand is likely to have had the effect of pushing interest rates down for a number of countries, whose governments found it therefore much easier to fund their electoral promises. In the end, the financial and economic crisis was triggered by the over-issuance of very specific types of debt: housing/mortgage, sovereign and some structured products. All those asset classes had one thing in common: a preferential capital treatment under Basel’s banking regulations.

Basel 2 introduced some granularity but fundamentally didn’t change anything. Basel 3 doesn’t really help either, although local and Basel regulators have recently announced possible alterations to this latest set of rules in order to force banks to apply risk-weights to sovereign bonds (one option is to introduce a floor). Some banks have already implemented such changes (which cost billions in extra capital requirements).

While those measures go in the right direction, Basel 3 has also introduced a regulatory tool that goes precisely the opposite way: the liquidity coverage ratio (LCR). The LCR requires banks to maintain a large enough liquidity buffer (made of highly-liquid and high quality assets) to cover a 30-day cash outflow. As you may have already guessed, eligible assets include mostly… government securities**.

Here again, Basel artificially elevates the demand for sovereign debt in order to comply with regulatory requirements, pushing yields down in the process. This has two consequences: 1. governments could find a lot easier to raise cash than in free market conditions (with all the perverse incentives this has on a democratic process unconstrained by economic reality) and 2. as sovereign yields are used as risk-free rate benchmarks in the valuation of all other asset classes, the fall in yield due to the artificially-increased demand could well play the role of a mini-QE, boosting asset prices across the board ceteris paribus.

We end up with a policy mix that contaminates both central banks’ monetary policies and domestic political debates. But, worst of all, it is a real malinvestment engine, which trades short-term financial solidity for long-term instability.

* Some non-OECD regions of the world also allow their domestic banks to use 0% risk-weight on domestic sovereign debt. For instance, many African countries are allowed to apply 0% weighing on the sovereign debt of their local governments despite the obvious credit risk it represents as well as its poor marketability (this is partly mitigated as this debt is often repoable at the regional central bank). Moreover, the same regulators prevent their domestic banks from investing their liquidity in Treasuries or European debt, with the obvious goal of benefiting those African states. Consequently, illiquid and risky sovereign bonds comprise most of those banks’ “liquidity” buffers, evidently not making those banking systems much safer…

** The LCR is partly responsible for the ‘shortage of safe assets’ story.