Sunday, December 11, 2011

Basel rules may be a cause of the current debt crisis

The capital haircuts for banks will cause portfolios to be skewed in directions that may create risk as well as cut risk. Government bonds have the lowest capital risk weighting. For your home country bonds government bonds are assumed to be risk-free assets. What do you think banks will do? they will load the boat on the risk-free assets even when they have risk versus other assets. Government bonds cannot default because governments have the power to tax. How is that working for Greece and Italy? How about the low risk weightings for mortgages? That did not work very well. 

The Basel risk-weighting for sovereign debt is a form a financial repression by governments. By maintaining the fiction that government bonds are safer, they force banks to hold risky assets which they should not. The governments have unwilling but large buyers of their debt. Government bonds may not have significantly more risk than corporates in many cases but banks will not be allowed to decide on those risks when the capital charges are different. Even if the market prices the government debt at a higher yield there will be an incentive to hold the risky debt. What happens now that S&P places so many sovereign on credit watch in the EU? We will have to rethink the idea of government risk weighting. This issue should not wait.

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