The world's central banks recently signed off on the Basel III rules for bank capital. The new system, years in the making, is a step forward: It will make banks stronger and safer. But there are several loose ends. One of the most important concerns the treatment of sovereign bonds on banks' balance sheets.
Banks that hold large, concentrated portfolios of their own governments' bonds can be a threat to financial stability. This practice needs to be discouraged. Unfortunately, the Basel Committee decided, for now, not to act.
National regulators can choose to treat government bonds denominated in domestic currency as safe — and they do. All the committee members use this freedom to set the risk weight on such bonds at zero. This means their banks can load up on domestic sovereign bonds without needing to raise any more capital.
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As a result, some banking systems serve as major creditors to their respective governments. According to a study by the Bank for International Settlements, government debt represents more than 10% of banks' assets in countries such as Spain and Japan. In Italy, it's nearly 20%.
These holdings pose a danger. If investors turn against those bonds, they might inflict severe losses on the banks concerned. If governments then have to step in, issuing more debt to meet the cost, the value of the bond holdings might fall again as the governments' creditworthiness is called into question — the so-called "doom loop" that can turn a banking upset into a fiscal and financial crisis.
