I am aware that banks as well as governments are afraid of rising funding costs as a result of ending the regulatory privileges afforded to sovereigns. The argument goes, moreover, that such a regulatory move risks considerable market turmoil. I do not think that this argument should keep us from doing the right thing.
No market participant would judge a French bond to be as risky as a Greek one: the riskiness of each is reflected in their prices. Investors believe that sovereigns differ in terms of riskiness. So no one should be surprised when the regulatory treatment accommodates this fact.
If additional capital requirements for European banks were imposed to cover sovereign exposures, the extra capital would be almost negligible on aggregate – albeit with substantial differences between banks. Other measures, such as the inclusion of sovereigns in the large exposures regime, might lead to more substantial repercussions, but these would be manageable if introduced over a transition period – which undoubtedly has to be granted.
When it comes to funding costs for governments, a healthier banking system with better diversification would pose less of a burden on states. The contingent liabilities of the government would shrink which – all other things being equal – would reduce the risk of investing in sovereigns and, eventually lower the sovereign bond yields.
The current regulation’s assumption that government bonds are risk-free has been dismissed by recent experience. The time is ripe to address the regulatory treatment of sovereign exposures. Without it, I see no reliable way of breaking the sovereign-banking nexus.
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