On Ending The Eurozone's "Diabolical Loop"

Tyler Durden's picture


Authored by Lucrezia Reichlin and Luis Garicano, originally posted at Project Syndicate,

The eurozone is caught in a diabolical loop, in which weak banking systems harm their sovereigns’ fiscal positions, which in turn compromise the banking system’s stability. But, over the last couple of years, policymakers have focused largely on reducing banks’ impact on their sovereigns – for example, through a Europe-wide supervisory authority and efforts to establish a European resolution mechanism – while ignoring the feedback in the other direction.

Although eurozone sovereign-debt markets have stabilized, the share of sovereign bonds held by domestic banks has increased sharply in the last few months, accounting for more than half of the net increase in debt emissions in some countries.


In Spain and Italy, sovereign bonds now account for roughly 10% of banks’ total assets.

The risk is that any unexpected challenge faced by a weaker debtor country’s sovereign-bond market – say, Catalonia’s secession referendum, or the renegotiation of the Portuguese and Greek bailouts – will undermine bank solvency, often even more than in previous rounds of the feedback loop. Moreover, even in the absence of a crisis, the sovereign-bond market’s geographical segmentation hampers monetary-policy transmission substantially.

What accounts for banks’ growing bias toward their own country’s sovereign debt? And what should be done about it?

The most obvious suspect is Basel III, the new global regulatory standard for banks’ capital adequacy and liquidity. But, while Basel III favors sovereign debt in general by assigning it a zero risk-weight in calculating capital requirements, it does not favor home-country debt, at least not within the context of the eurozone. Indeed, Basel III treats all OECD government bonds in the same way, regardless of whether they are denominated in the issuing country’s own currency.

Likewise, while the European Central Bank’s collateral policy imposes different “haircuts” on bondholders depending on a country’s credit rating, it discriminates little between countries. In short, current bank regulation neither encourages nor discourages the home-country bias in banks’ sovereign-debt holdings.

In fact, eurozone banks’ preference for home-country sovereign bonds is rooted in a combination of factors, including fear of redenomination – a consequence of the crisis that leads banks to concentrate their risk domestically – and the expectation that bailout mechanisms will be national. Given that the eurozone lacks any supra-national fiscal backstop, such as a lender of last resort or a debt-mutualization mechanism like Eurobonds, the home-country bias can be expected to intensify whenever an economy experiences a significant shock.

Against this background, European policymakers and regulators must take action to encourage banks to diversify their sovereign-debt holdings. Of course, a common fiscal backstop (along with a single banking supervisor) would eliminate the bias. But there is strong resistance to the fundamental changes to the eurozone’s architecture that this would require.

A more feasible solution would be to introduce an explicit regulatory bias against home-country sovereign-debt holdings. This could be done in three ways.

The first option would be to place upper limits on the sovereign debt held by banks – for example, by eliminating the current exemption of zero-risk sovereign bonds from regulators’ so-called large exposure regime. But administrative caps are a blunt instrument that introduce new nonlinearities and opportunities for arbitrage and speculation. And weaker sovereigns, legitimately fearing that such a scheme would suppress demand for their debt, would almost certainly block it.

Another potential solution, proposed by the euro-nomics group in 2011, would be to create “European Safe-Bonds” (ESBies). A European debt agency would purchase eurozone countries’ sovereign bonds, weighted according to each country’s contribution to the eurozone’s GDP, and use them as collateral to issue two securities. The first security, the ESBies, would be composed of the senior tranche of the bond portfolio, and would serve as the “safe asset,” while the second, risky security would be sold to investors in the market.

ESBies would effectively fulfill the role of Eurobonds, but without the joint and several liability that would demand treaty changes. Though the lack of such debt mutualization has caused weaker sovereigns to resist ESBies, while stronger sovereigns contend that ESBies still demand excessive risk-sharing, this solution could gain traction in the event of another crisis.

The third option would be to introduce a new rule conditioning sovereign bonds’ zero-risk weight on banks’ willingness to hold them in certain proportions – for example, relative to GDP. Although a transitional regime would be needed to avoid hurting banks in weaker countries, such a rule would dramatically reduce banks’ exposure to home-country sovereign debt. Indeed, it could help to encourage the market-driven creation of a eurozone safe asset – a kind of non-regulatory ESBie.

Regardless of the approach, one thing is clear: European policymakers and regulators must act now to eliminate the negative feedback loop between sovereigns and their banks. Waiting for another crisis to strike could have devastating consequences for both.

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Mon, 01/27/2014 - 16:04 | 4372267 LawsofPhysics
LawsofPhysics's picture

Please, there is only one "solution" to years of bad behavior, theft, and fraud, not to mention capital and resource mis-allocation and mal-investment.

Let the hunger games begin...

Mon, 01/27/2014 - 16:26 | 4372332 DutchR
DutchR's picture

yes, but for whom.....

Mon, 01/27/2014 - 16:27 | 4372334 wintermute
wintermute's picture

A feedback loop is always positive, even when negative. A positive feedback loop with negative consequences is what needs breaking by an external agency

Mon, 01/27/2014 - 16:41 | 4372378 NoDebt
NoDebt's picture

Why does everying always involve "urgent policy action by governments and regulators"??

If they botch up their risk management and run the bank up on the rocks, F 'em.

Isn't all this centralized policy management BS how we got in this mess to begin with (and definitely one of the big reasons we're not climbing up out of it)?  Oh, big daddy government, please save me!  Bullshit.

Mon, 01/27/2014 - 16:04 | 4372269 unrulian
unrulian's picture


Dr. Evil: As you know, every diabolical scheme I've hatched has been thwarted by Austin Powers. And why is that, ladies and gentlemen?
Scott: Because you never kill him when you get the chance, and you're a big dope?

Mon, 01/27/2014 - 16:11 | 4372294 Sudden Debt
Sudden Debt's picture

doomed... we had it comming...

Mon, 01/27/2014 - 16:22 | 4372325 TheFourthStooge-ing
TheFourthStooge-ing's picture

C'mon, they're all zero-risk. What could possibly go wrong?

All hail the recovery!

Mon, 01/27/2014 - 16:14 | 4372295 Colonel Klink
Colonel Klink's picture

Fuck the banks and the sovereigns.  Both were stupid and corrupt enough to let it happen.  The citizens should act now to get out of the way of the asset confiscation which is coming.

Mon, 01/27/2014 - 16:18 | 4372312 PontifexMaximus
PontifexMaximus's picture

Only 10 %? There is much more room left to push up the bal sheet, take a lesson from JY. And, don't forget, dear ivory tower wroters, there is superMario in Frankfurt, never forget that!

Mon, 01/27/2014 - 18:59 | 4372865 Ghordius
Ghordius's picture

+1 that number used to be way higher from the 50's to the 90's

the authors just want a big eurobond. synthetic, if necessary

Mon, 01/27/2014 - 16:20 | 4372317 Jack Burton
Jack Burton's picture

And imagine, this is the EU that is pulling out all the forces it has available to foment a revolution in Ukraine and bring it in as a full EU member. The government was going to sign the EU deal offered, until it read what the EU demaded by way of austerity, tax rises, pay cuts, factory shut downs and social welfare cuts, including health care. Add to that a demand for a 40% instant rise in energy price in the Ukraine. How could government sign that, the people would have revolted. But now they revolt because that deal wasn't signed. The EU in no way has the money to rescue a Ukrainian economy that would collapse if faced with EU membership. Germany would flood the Ukraine with imports, and big EU retailers would flood imported Chinese goods into mega stores. Fact is, both industry and retail in the present Ukraine would collapse in that case.

We need to look beyond economics for the answer to the revolution in Ukraine. That is provable based on the evidence. This is a big push by NATO armed forces to set up military forces on Russia's southern flank. And in Ukraine the people in revolt are western Ukrainians with Catholic religion and close ties to Poland. While the East and south of Ukraine is Orthodox Christian and tied very closely to Russia and is largely ethnic Russian. The parliament in the Crimea has already passed a bill to defend Crimea from any intervention by the western revolutionary forces and has already raised 5,000 men to aid law enforcement to defeat any uprising or intervention by pro EU nationalists from western Ukraine. Much the same has happened in south Ukraine and parts of the industrial east. The EU is fomenting a civil war, a war that will split Ukraine and leave the EU with the western rump of Ukraine, and an economic basket case. Russia will absorb a pro Russian South, Crimea and East Ukraine. This, the industrial and mineral heart, will go to Russia and the Crimea and the great naval base of the Black sea fleet will become Russian. The EU and USA think they are going to win big in Ukraine, they are wrong, they will lose their asses! And the west Ukraine will be another failed economy on the back of Brussels and the EU taxpayers. Watch this story develop, it is the biggest story of 2014 for the USA, EU and Russia. Inside Europe that is. Russia is sitting back and letting this develop, they do not need to act, the pro Russian elements that make up 50% of the Ukraine are already preparing for action to defend their interests. Remember, CNN will show you a crowd of pro EU revolutionaires in Kiev, this is real, BUT, they are a tiny fraction of that nation, the big story is outside Kiev. West and East/South are headed for a split, and the EU can not stop it.

Mon, 01/27/2014 - 17:30 | 4372574 reload
reload's picture

Great synopsis Jack, about time ZH put some of your cohesive insights out as posts.

As an aside BBC TV just broadcast a documentary highly critical of the corrupt allocation of Stochi winter Olympics construction contracts. the title was 'putins games' and his close circle was seriously implicated.

Not really news, except 12 months ago our state media mostly portrayed Putin as a hard man who had overseen massive Russian economic growth.

The film ended with the statement that 'not a single western leader has yet accepted the invitation the attend the games'

Putin is fast becoming the new bogeyman.

Mon, 01/27/2014 - 18:54 | 4372845 TheFourthStooge-ing
TheFourthStooge-ing's picture

Have to agree with reload on both observations.

I'll always stop to read a comment from Jack Burton. He's a big-picture thinker and expresses his thoughts well. Also, although he hasn't done it for awhile, he's a deadly sarcastician. His artful subtlety, while a hilarious delight for the careful reader, can be merciless in its ablility to get people to take the bait.

Regarding Putin, he's definitely the New York - London - Vichy DC crime gang's new bogeyman. Hard to believe that no crooked deals went on behind the scenes of the 2012 London Olympics. I can't even imagine the framework of corruption on which the Tokyo 2020 Olympic Games are being built.

Remember, the way of the sociopath is that the acts of which one is secretly guilty are the same acts vehemently denounced when accusing others. Sometimes this requires a specific bogeyman instead of a general one. For instance, when making accusations of corruption in Olympics contracts, it's easier to create a narrative involving Putin than it would be to create one blaming Al Qaida for awarding Olympics contracts to terraist-operated construction companies.

Mon, 01/27/2014 - 16:33 | 4372356 Joebloinvestor
Joebloinvestor's picture

The "Bail in" has already been established, and they are trying capital controls.

They completely ignore the obvious.

If you want people to have faith and trust the "system", start seriously prosecuting banksters and their cronies.

Allowing jackasses like Hollande to pay more attention to whom he is sleeping with and scooter riding is one reason why Europe is what it is.


Mon, 01/27/2014 - 16:52 | 4372426 NaiLib
NaiLib's picture

scchh dont tell them the truth. This is the German squeeze of the rest. Bail in for everybody except the Germans :)

Mon, 01/27/2014 - 17:27 | 4372564 Spungo
Spungo's picture

The fear of bail-ins would greatly re-capitalize Germany's banks and lower the yield on their bonds as rich people move their money into Germany.

Mon, 01/27/2014 - 18:29 | 4372768 Umh
Umh's picture

The refusal to let banks (and others) fail is why the current predicament has lasted as long as it has.  I truely believe that trying to catch all the falling plates is a serious mistake. When you drop a knife in the kitchen the thing to do is get your feet out of the way, not to hit the knife and send it going in some unknown direction and my toes agree.


Tue, 01/28/2014 - 05:18 | 4374291 limit_less
limit_less's picture

NoDebt - Of course centralised control f'ed the whole thing up. Why more centralised control? Because the money centre banks have made a fortune off the "crisis" Look how much more money they are making off Greek government now compared to before the crisis. The Greek government is taxing the people into homelessness, it is spending massively less inside Greece and the difference is going to the holders of Greek government debt ie the money centre banks. They love it.

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