Allowing banks to hold sovereign debt against the lowest capital is evil, as it dooms nations to unsustainable levels of public debt.

Sir, Miles Johnson, Kate Allen and Federica Cocco report “Italian bank shares were hit yesterday after the Fitch credit rating agency said banks’ balance sheets were under pressure because of their exposure to Italian government debt.” “Italy’s central bank warns of slowdown” October 21.

Here we go again!

In a 2002 Op-Ed titled "The Riskiness of Country Risk I wrote": “What a difficult job for those assigning credit ratings to sovereigns! If they overdo it and underestimate the risk of a given country, the latter will most assuredly be inundated with fresh loans and will be leveraged to the hilt. The result will be a serious wave of adjustments sometime down the line. If on the contrary, they exaggerate the country’s risk level, it can only result in a reduction in the market value of the national debt, increasing interest expense and making access to international financial markets difficult. The initial mistake will unfortunately turn out to be true, a self-fulfilling prophecy. Any which way, either extreme will cause hunger and human misery.

In his book The Future of Ideas: The Fate of the Commons in a Connected World” Lawrence Lessig maintains that an era is identified not so much by what is debated, but by what is actually accepted as true and so is not debated at all. In this sense, given the risk that the perceived country risk actually becomes the real country risk, it is best not to assign an AAA rating blithely to credit rating agencies—perhaps not even a two-thumbs-up.”

In 2004, in a letter published by FT I asked “How many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector?” 

Then by means of the “Sovereign Debt Privileges” or “Equity Capital Privilege” enacted by EU authorities, Greece was assigned, for the purpose of the risk weighted capital requirements for banks, a 0% risk weight... and consequently it went down the tubes.

A 2017 paper by Dominik Meyland and Dorothea Schäfer titled “Risk weighting for government bonds: challenge for Italian banks” and produced by the German research institute DIW Berlin states: “Although banks are required to document their equity capital for loans, corporate bonds, and other receivables, they are currently exempted from the procedure when investing in government bonds: they enjoy an “equity capital privilege.” As part of the Basel III regulatory framework redraft, the privilege may be eliminated in order to disentangle the default risks between sovereigns and banks. The present study examines how much additional equity capital the banks of the euro area’s major nations would require if the equity capital privilege were eliminated. At nine billion euros, the estimates show the highest capital requirement for Italian banks… The primary reason for this is that Italian banks hold relatively large amounts of Italian government bonds” 

That paper was written when “Italian government bonds had a Fitch Rating of BBB+, yielding a risk weight of 50 percent based on the [Basel II] standard approach.”On August 31 Reuters reported “Fitch Ratings on Friday cut Italy’s sovereign debt outlook to ‘negative’, citing expectations that the new coalition government’s fiscal loosening would leave the country’s high levels of debt more exposed to potential shocks.” If Italy’s rating drops further, those capital requirements would only increase… or worse losses having to be recorded.

I wonder if EU will put the blame solely on Italy as they did with Greece, ignoring they caused the tragedy with their “Sovereign Debt Privileges”.

The DIW Berlin paper also states: “German banks also exhibited a strong home bias, but German government bonds have an AAA rating. Unlike the Italian banks, the German banks’ home bias is thus inconsequential regarding the banks’ capital needs.”

So I would say that Germany is also on the same 0% sovereign risk weight road that took down Greece, and sadly, perhaps Italy too.

When will they ever learn? 

@PerKurowski