PRIMED FOR ANOTHER CRISIS ? / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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DECEMBER 23, 2009, 12:22 P.M. ET.

Primed for Another Crisis?

By PETER EAVIS

Subprime securities whacked the banking sector. Could lenders now face a not-so-prime sovereign crisis?

As government, or sovereign, borrowers rack up large fiscal deficits, banks have been big buyers of their debt. One reason: In a shaky economy, banks are looking for safer alternatives to corporate and consumer loans.

But another is that banks get to hold zero, or little, capital against government obligations. That's because many sovereign bonds have high credit ratings, just like many subprime securities when they were first issued. Taking away this advantageous capital treatment could "provide a needed form of market discipline against the government," says Nicole Gelinas, of the Manhattan Institute.

Governments aren't likely to favor adjustments to a system that helps to create demand for their debt. But at a time when international banking regulations are being overhauled, central bankers could press for ratings to play less of a role in capital-setting, thus reducing the risk that banks will overload on sovereign debt.

Greece's fiscal crisis reveals the need for change. Demand for Greek government bonds has dried up, making it harder for banks to use them as collateral for their own borrowing. As a result, the European Central Bank has had to step in to make loans against them, even though Greece's ratings have been cut.

And Japan's recent history shows how a dysfunctional relationship can develop between a high-spending government and a banking sector.

Japanese gross government debt will amount to 219% of gross domestic product this year, the International Monetary Fund estimates, compared with 120% in 1998. Back then, Japanese government bonds made up just 4% of Japanese bank assets, while loans accounted for just over 60% of assets, according to Pali Capital. Now, after government debt has skyrocketed, government bonds account for 15% of assets, whereas loans have fallen to 54%, according to Pali.

In the U.S., Treasurys make up only 2.32% of assets at large commercial banks. But adding in securities issued by entities like Fannie Mae and Freddie Mac, called agency debt and both effectively backstopped by the government, takes the sovereign exposure up to 12.3% of bank assets.

What is more, in the past 12 months, large bank holdings of Treasurys and agency debt have risen 8.5%, while loans have fallen 6%.

True, governments can print money to honor obligations. But if investors fear the printing will irreparably debase the currency, government-bond prices would plunge, causing losses for banks holding them. Indeed, history shows that losses on government debt due to outright default or high inflation are real risks. Since 1900, there have been three big sovereign loss cycles, according to economists Carmen Reinhart and Kenneth Rogoff.

Granted, one proposed reform to international banking regulations could indirectly help. This is the introduction of a supplementary ratio that limits the amount of assets a bank can hold for a given amount of capital. Because this wouldn't use risk weightings, based on credit ratings, there would be less incentive for banks to load up on relatively low-yielding government paper.

A straight leverage ratio like this could be diluted by countries with banks that would look weak under it. And though such a standard has long existed in the U.S., it didn't stop banks from ramping up exposure to Fannie and Freddie securities in the early 1990s, only to suffer losses when interest rates rose in 1994.

It is time for regulators to make the banks think twice before bowing to sovereigns.

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