May 20, 2015

Martin Wolf: Sovereigns = 0% risk weight; citizens = 100%. Are not regulations relevant to sovereign bond markets?

Sir, Martin Wolf discusses lengthily the history and possible future of the current low yields of sovereign bonds, “The wary retreat of the bond bulls”, May 20.

Surprisingly, or perhaps not so surprisingly, Wolf fails to even mention the absolutely extraordinary development that took place with the signing of the Basel Accord in 1988. In that accord, regulators, decided unilaterally and with no explanations given, that for purposes of the equity banks needed to hold, the sovereigns were assigned a risk weight of zero percent, while the citizens, those who really constitutes the backing of a sovereign, were risk-weighted with 100 percent.

That of course meant that those interest rates which were used as proxies for the risk-free rate, became subsidized risk-free rates and are not at all comparable to what existed before 1988.

That of course meant that banks would earn immensely higher risk-adjusted returns on equity when lending to the sovereign than when lending to the risky.

In November 2004 in a letter published in FT I wrote: “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. 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 (sovereigns)?” More than a decade later I still ask the same question and many still prefer to ignore that.