Jabłecki, Juliusz. "The European Sovereign-Debt Crisis: A Failure of Regulation?". Critical Review, Vol.24, No.1 (2012): 1-35.

Jabłecki, Juliusz. "The European Sovereign-Debt Crisis: A Failure of Regulation?". Critical Review, Vol.24, No.1 (2012): 1-35.

• Inadequate banking regulation was one of the factors leading to the 2008 financial crisis, particularly the combination of strict capital adequacy requirements under the Basel II Accords and numerous loopholes to these requirements. These rules led banks to prioritize highly-rated bonds and securities, particularly mortgage-backed securities, because they carried lower capital requirements (2).
• Banks were similarly incentivized to purchase European sovereign debt because it was highly rated, regardless of the actual solvency of the government in question, and thus carried lower capital reserve requirements. This did not make borrowing significantly cheaper for European governments, nor did it encourage profligacy, but it did lead to banks holding large amounts of sovereign debt (2-3, 28).
• The relative cheapness of borrowing for EU governments does not seem to have a significant impact on the fiscal decisions of those government, as demonstrated by Greece accumulating most of its debt in the period between 1979 and 1992, when borrowing costs were the highest (10).
• Banks finance loans with either capital saved from past earnings or through debts, either borrowing from depositors or purchasers of bank bonds. Large capital reserves insulate banks to losses and allow them to repay their debts, but financing loans from debt is cheaper for banks than doing so from capital (3).
• Banks tend to prefer debt financing to capital financing because of the additional profits, so governments enforce capital adequacy requirements to prevent banks from assuming too much risk and being unable to pay their debts. In 1988, expected levels were set internationally in the Basel Accords, which linked capital adequacy requirements to risk, meaning riskier investments required greater reserves (3-4).
• Under the original Basel I Accords, capital reserves had to equal 8% of risk-adjusted assets. Some assets were considered safe enough that they required smaller capital reserves: mortgages were weighted at 50%; debt issued by government-sponsored entities was weighted at 20%; and the sovereign debt of OECD members had a weight of zero, meaning holding OECD sovereign debt did not require any capital reserves (4).
• The Basel II Accords, created in 2004, addressed the nonsensical distinction between OECD and non-OECD sovereign debt by basing the weighted risk of sovereign debt on its risk according to ratings agencies or the banks themselves under the supervision of regulators, with only sovereign debt rated AA- or higher not requiring capital buffers (4-5).
• In the EU, the Basel II Accords were transposed as the Capital Requirements Directive in 2006. They included the updated risk-assessment of sovereign debt for most countries, but kept a rule that the sovereign debt of all EU member states should be treated as risk-free and thus not require capital reserves (5).
• By not demanding any capital reserves for holding EU sovereign debts, this regulation essentially encouraged banks to purchase the riskiest sovereign debt because such debt would carry the highest returns but did not come at the cost of additional capital adequacy requirements. This was publicly recognized by banks at the time (5-6, 12).
• The EU decision to set zero capital adequacy requirements for EU sovereign debt meant that bond yield rates on different EU member states' sovereign debt were essentially the same, despite massive differences in fiscal health and economic performance. This may be partially related to incentives to purchase riskier EU sovereign debts, but also results from a general underestimation of risk globally and the elimination of currency exchange risk and inflation risk due to the creation of the Eurozone. (6-9).
• Market discipline was enforced on less sound EU member state governments, with German sovereign bonds having lower yield rates than Italian, Greek, or Portuguese equivalents. However, such difference were small in the context of a general convergence due to global underassessment of risk (9-10).
• Most Eurozone governments did not have outrageously bad public finances prior to the 2008 financial crisis; they were bad, but roughly comparable to British, American, or Japanese finances. Their financial situation began to drastically worsen with the 2008 financial crisis and the subsequent decline in tax revenue and increase in public spending (11).
• A core dynamic of the sovereign debt crisis in Europe was that the precarity of sovereign debts held by European banks led to solvency issues in those banks, to which European governments responded by bailing out banks, but this was financed through issuing more sovereign debt, which only increased fears of the trustworthiness of existing sovereign debt, and thus the solvency of banks (12-13).
• The massive sovereign debt holdings of European banks meant that markets treated the solvency and creditworthiness of banks as linked to governments, as visa-versa. This was expressed in a mutual rise in the insurance rates on credit default swaps for both sovereign debt and bank bonds (25), and higher interest rates on loans for both banks and governments (27).
• It makes sense for European banks to hold European sovereign debts, as banks are often given special privileges in return for participating in the bond auctions of their domestic government (13). European banks still had investment profile with much more sovereign debt than those of British or American banks, and this investment actually increased after 2008 as banks sought the supposedly stable and liquid asset of sovereign debt (14-15).
• The greater investment in sovereign debt in the Eurozone versus the USA and Britain cannot be explained by its lack of capital reserve requirements, as Britain had the same rule and the USA still operated according the rules of the Basel I Accords. This divergence is explained by the greater availability of highly-rated corporate bonds in the USA and their relative scarcity in Europe, meaning that sovereign debt was often the only safe euro-denominated asset available to European banks (16-17).
• European banks were further incentivized to hold sovereign debt because, in addition to not having any capital reserve requirements, banks were also exempted from large-exposure rules that prohibited them from having any asset that exceeds 25% of total capital. Together, these rules essentially allowed banks to purchase as much sovereign debt as they could afford, resulting in holding in sovereign debt far in access of capital reserves (17-18).
• The introduction of new liquidity requirements in December 2010 as part of the Basel III program further increased the incentives for European banks to hold sovereign debt, as sovereign debt was, along with cash and central bank reserves, an acceptable form of liquid asset. Banks were thus buying sovereign debt during 2010 and 2011 to try to meet these new liquidity requirements (19-20).
• In 2011, the European Banking Authority introduced new regulation that banks had to establish a 9% capital buffer by July 2012, with sovereign debt now only counting toward the reserve amount based on its market value, which was roughly 30% lower than its recorded value in banking books (22).
• The measure was fiercely criticized at the time for jeopardizing banks because it simultaneous exposed the precarious situation of bank holdings to financial markets and demanded that banks raise additional capital during a recession, exactly when it was most costly for banks to borrow. Understanding the difficulty of selling equity and the risks of buying sovereign debt, banks mostly chose to cut off credit in order to shrink their balance sheets and thus lower their capital reserve requirements (22-23).
• An essential fault in the idea that EU sovereign debt should carry no risk is that, whereas most governments can theoretically print money to meet their debt obligations, Eurozone member states do not have this power, which is instead held by the European Central Bank. This means that default in possible, since in the case of a sudden budget crunch, as occurred in 2008, governments may choose to default on debts in order to prioritize pensions and welfare payments over repaying investors (18).
• The transposition of the Basel III Accords into EU law in July 2011 did not change the exempt status of EU sovereign debt from capital adequacy or large-exposure regulations. The primary change was that banks needed a greater proportion of their capital to come from saved earnings and bond sales. Less capital could now be raised from stock sales (18-19).
• Banks could meet these new requirements either by increasing their capital reserves through bond sales or increased savings, or by reducing their total capital adequacy requirements by reducing their involvement in standard loans and shifting towards the purchase of sovereign debt, which carried no capital reserve requirements (19).
• European banks generally recorded their ownership of sovereign debt on the 'banking book' rather than the 'market book', meaning that reduction in the market value of those assets reduced equity without being directly recorded as loss on bank account books, because recording it on the market book would have activated capital reserve requirements. Although valid from an accounting perspective, this meant that regulators greatly underestimated the losses incurred by European banks and their vulnerability (20-21).