MAY 10, 2010.
Government Bonds Aren't Such a Capital Idea .
By DAVID REILLY
Banks piled into housing debt during the credit boom. When that turned to bust, many sought safety in government bonds.
Investors have to hope they didn't jump from the frying pan into the fire, given fears that the euro zone could unravel and spark a rolling sovereign-debt crisis. But, if the worst were to occur, banks alone wouldn't be to blame. Rules governing bank capital would have also played a role.
These often give banks an incentive to bolster balance-sheet strength by switching into government debt rather than taking the painful route of raising more equity. That can concentrate banks' exposure to sovereign-debt risk, reduce money that would have been lent to boost the economy, and funnel money to profligate nations—delaying needed reforms.Regulators are "creating warped incentives to encourage the purchase of sovereign debt," Michael Pomerleano, a World Bank adviser, wrote earlier this year. "Banks short on capital and reluctant to lend in a risky setting are given an easy choice to pile into government debt."
Regulatory rules apply formulas to determine the risk of different assets, so banks need more or less capital against them depending, say, on whether they are government debt or corporate bonds.
In theory, this makes sense. Yet government debt, which generally receives the most favorable risk treatment, isn't always safe. This can leave banks looking stronger than they are. A bank can raise regulatory capital measures, such as its Tier 1 ratio, by parking more holdings in government bonds, even as equity remains unchanged.
So even if the Greek crisis is contained, supposedly well-capitalized banks could still have a headache. Any restructuring of Greek debt, for example, could force France and Germany to recapitalize some banks, according to Citigroup Chief Economist Willem Buiter. Banks in those countries have more than €110 billion ($140 billion) in Greek exposure, although Greek sovereign-debt holdings vary from bank to bank.
And while the risks from a European meltdown appear more concentrated there, the trend of banks increasing holdings of government debt is clear, even in the U.S.
J.P. Morgan Chase & Co. and Citigroup Inc., for example, in 2009 increased holdings of supposedly safer government and government-backed securities by about 29%, even as they trimmed their balance sheets. Both banks also increased holdings of non-U.S. government bonds. J.P. Morgan's rose $36.5 billion to $83.4 billion. Citigroup's increased by almost $40 billion to about $175 billion, or 9% of assets. Bank of America said in its first-quarter securities filing on Friday that foreign sovereign debt increased 27% to $35.8 billion; it provided additional disclosure about exposure to at-risk European countries, saying this was about $3.1 billion.
Financial markets have again woken up to the fact that government debt isn't always risk-free. Capital rules for banks should do the same.
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