Italy’s problems are not all of its own making; much is caused by a regulatory mistake committed by bank regulators and the European Commission.

Sir, Franco Debenedettiwrites “The flexibility accorded by Brussels was used neither for reducing the debt, nor for implementing the ‘painful structural reforms to promote growth’ [and] The budget actually under examination by Brussels is all about more public expenditure employed for giveaways and does nothing to improve productivity and growth of the country, “A bargain with Brussels looks unrealistic”, November 19.

He is correct, in that, but he leaves out a crucial element that is an essential part of current realities.

Basel II, approved in June 2004, held that banks as Italy was rated at that time, AA-, needed to hold 1.6% in capital against Italy’s sovereign debt. Currently rated BBB, banks were supposed to hold 4% in capital against that debt. But the European Commission then surpassed those per se already extremely generous and pro statist capital requirements. Through “Sovereign Debt Privileges” it assigned a 0% risk weight on Italy’s sovereign debt; which meant banks did not need to hold any capital against it.

That allowed (or in reality forced) Italy’s banks to end up with a huge overexposure to Italian sovereign debt in Euros, a debt that de facto is not denominated in Italy’s domestic (printable) currency.

What to do? Any solution is going to hurt, but one has at least the right to ask whether Italy, as was Greece, should have to carry the whole costs of a mistake committed by the European Union authorities.

To top it up, there is no way one can improve productivity and growth of any country that distorts the allocation of bank credit to the real economy, as do the risk weighted capital requirements for banks.

@PerKurowski