The crises of recent years have shown us that we must part with many convictions held in the past. One of them is that government bonds are risk-free. This also applies to bonds issued by member countries of the European Monetary Union (EMU). The reason for this is simple: Despite having a common currency, the member countries remain liable for their own debt, at least in accordance with the European treaties.

Up to one third of this government debt is on the balance sheets of banks in the EMU. For them, these assets – in the form of bonds or loans – are therefore not risk-free from an economic perspective. Nevertheless, regulators have treated them as risk-free assets, exempting them from capital requirements and large exposure regimes.

These false incentives have – also in the interest of governments – led to a situation where risk premiums of government bonds are too low and banks have lent enormous sums to sovereigns, especially to their home countries. This has created a fatal nexus between banks and governments, which can still jeopardize the stability of our financial system.

Targeted Regulation

This has spurred into action regulators who want to put an end to this situation. In my view, several goals are to be pursued in this context:

  • On the one hand, banks should not let their holdings of sovereign debt grow too large or reduce them if necessary, but in any case they should diversify them to a larger extend.
  • On the other hand, governments of the EMU member states should be incentivized for managing their debt in such a manner that it no longer poses a risk to the banking system.
  • As a result, the risks of contagion between banks and governments would diminish, and the financial system would become more stable and crisis-resistant.

A necessary regulation needs to follow at least four principles:

  1. It should prescribe adequate capital requirements for sovereign bonds and loans,
  2. Continue to allow banks to fulfil their current regulatory liquidity requirements,
  3. Avoid circumvention of the rules, and
  4. Differentiate exposures by its economic risk

However, to simply lift all regulatory privileges existing for sovereign debt and subject them, like corporate loans, to capital requirements and large exposure limits, is not a viable solution. This is because as debtors, governments still differ from companies. And as a matter of fact it has become clear in the crisis: Sovereigns also differ from each other in terms of credit quality.

Therefore, an across-the-board application of the large loan regime to EMU sovereign exposures would not only be too restrictive. It would also not be risk-sensitive and would again set wrong incentives.

The Proposal in Detail

I therefore propose a solution that combines several regulation approaches*: We need capital requirements for each individual sovereign exposure. These requirements would apply above an exemption level, which would differentiate the risks of each EMU country. This raises the question how these risks could be calculated.

Compared to corporate loans, there is much less empirical default data available for government debt, which makes modelling difficult. For this reason country- specific exemption levels for each exposure should be calculated on the basis of readily available indicators.

Suitable for this purpose are bank’s own funds (risk bearing capacity) and a country’s debt-to-GDP ratio (risk of the sovereign). My proposal assumes a standard exemption level of 25% of the bank’s own funds, in analogy to the large exposure regime for loans to other debtors. This amount would be weighted with the debt-to-GDP ratio in such a manner that the exemption level rises when the debt ratio is below 90% – and vice versa.

In addition, there would be a factor that prevents an excessive concentration of an individual bank’s exposure in the country’s creditor structure (diversification).

When an individual exposure exceeds the country specific exemption level calculated in this manner, it would have to be backed by regulatory capital. Theoretically, an institution could build up exemption levels that do not need to be backed by capital vis-à-vis a variety of countries, thereby accumulating a total exposure that is excessive and circumventing capital requirements.

The proposal also aims to prevent such regulatory arbitrage by implementing a maximum exemption level of 150% of its own funds. When the sum of used exemption levels exceeds this level, the exceeding amounts would also have to be backed with regulatory capital.

Risk weights would rise progressively with the total exceeding amount. Within the framework of this 150% ceiling, most banks would also be able to fulfil their supervisory liquidity requirements.

Note that the individual exposures itself would not be limited. Instead, this decision would still be at the discretion of the bank, but increasingly constrained by the need to provide regulatory capital for the amounts exceeding the 150% ceiling. The large loan exposure limit would therefore not be directly applied to sovereign debt in the future either.

Equity Capital Remains the Crucial Factor

The bank’s eligible own funds would still play a key role in this proposal – as assessment basis and as a scarce resource. At the same time, this is an indicator- and rule-based approach. In this way micro- and macro-prudential instruments are linked with each other. The concentration on only a few variables makes the proposal transparent, comprehensible and easy to implement.

A review of the proposed calibration and risk weights based on data published by individual banks show that the proposal would lead to additional regulatory capital requirements for those institutions that have not diversified their portfolios sufficiently or exhibit excessive exposures. This would create strong incentives:

  • For credit institutions to reduce their sovereign exposures, above all to their home country, or better diversify them; and
  • For governments to reduce their debt levels and better diversify their creditor structure, i.e. “place” less government debt with the domestic banking system than before.

In the future, sovereign risks within the EMU would therefore be spread over a larger number of banks in different member countries, i.e. the contagion risks would diminish. All in all, cross-border financial cohesion within the monetary union would increase, as would mutual financial disciplining by governments and banks or investors. More risk-appropriate premiums for government debt instruments would result in better capital allocation, and this would also benefit the project of the EU capital market union. Not only the individual credit institutions but also public finances and the financial systems would become more secure and resilient.

The introduction of such regulation requires analyzing the consequences and prerequisites very thoroughly impact studies beforehand. This should minimize structural changes, especially in the banks’ financing of the real economy. It would be up to regulators to determine the exact calibration of the parameters. My primary goal here is to identify key levers for a practicable and incentive-compatible solution and initiate a discussion about it.

The author is Chairman of the Board of Managing Directors of Commerzbank AG, Frankfurt a.M.

A German version of the article originally appeared in Frankfurter Allgemeine Zeitung, on April 7, 2015. Click here to read.