banking regulations

Cutting the Ties That Bind

ARCHIV - Die große Euro-Skulptur steht am 04.08.2011 in Frankfurt am Main vor der Zentrale der Europäischen Zentralbank (EZB). Die EZB hat den Leitzins im Euroraum erstmals seit Einführung des Euro 1999 unter ein Prozent gesenkt. Der Zins wird um 0,25 Punkte auf 0,75 Prozent verringert. Das beschloss der Rat der Europäischen Zentralbank (EZB) am Donnerstag (05.07.2012) in Frankfurt, wie die Notenbank mitteilte. Foto: Frank Rumpenhorst dpa/lhe +++(c) dpa - Bildfunk+++
Can new rules ring fence the damage when countries or banks go bankrupt?
  • Why it matters

    Why it matters

    New regulations are being considered to protect governments from banks that go bankrupt and also to protect banks when countries go bankrupt.

  • Facts

    Facts

    • The close bonds between financial institutions and countries has put some nations on the verge of insolvency because many banks loaded up on government securities because of their high interest rates.
    • A proposal crafted by the council would require governments with low credit ratings to back state securities with 25 percent equity capital.
    • Nations with strong credit ratings would not be required to meet the equity capital standards.
  • Audio

    Audio

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The close connections between banks and nations is exacerbating the crisis in the euro zone.

Some countries with previously low levels of debt are on the verge of insolvency after rescuing struggling financial institutions.

In the future, the European banking union – a project to harmonize rules, rescues and supervision across the currency bloc – should cushion the effects of bank insolvencies on the countries where the banks are headquartered. A “uniform liquidation mechanism” should guarantee that owners and outside creditors are held liable for bank losses, and that states should no longer have to foot the bill for banking crises.

It is unrealistic to believe governmental funds will  never again be used to save banks, but this at least should not be possible without the participation of private creditors.

With this regulation, however, the risky links between banks and states are being loosened in only one direction. It still doesn’t reduce the impact of government insolvencies on banks.

Government securities continue to receive special treatment in banking regulations...This maintains the fiction that government securities are completely safe.

European banks hold a large number of state securities and other claims vis-à-vis states, with a majority directed toward the bank’s home country.

This became even more extreme during the financial crisis. Banks, particularly those in southern Europe, used the favorable liquidity of the European Central Bank to purchase state securities offering a higher rate of interest.

This created a substantial cluster of risks on the banks’ books. Additionally, the introduction of regulations involving state insolvency is becoming difficult because restructuring state debts could cause a banking crisis.

Even so, government securities continue to receive special treatment in banking regulations. The limitation of large credits to 25 percent of net assets is not enforced on state debtors, so many hold state securities with a total value far exceeding their assets. There is no requirement to reduce risk by cushioning it with equity capital, and in the new liquidity regulation, state securities from member countries of the European Union are considered fully liquid. This maintains the fiction that government securities are completely safe.

To lessen the impact of state insolvencies on banks, the German Council of Economic Experts has developed a proposal for how state securities should be regulated in its most recent annual report.

 

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The fundamental provision is the reduction of cluster risks by limiting large credits. These limits depend on the creditworthiness of nations to assess the risk of respective state securities. The amount of claims toward states with the worst credit rating is limited to 25 percent of a bank’s net assets. The limit rises to 100 percent for states with the best credit rating.

In addition, claims toward states should be underlaid with equity capital by using proposals made by the Basel Committee on Banking Supervision regarding risk ratings for states, which are lower than those for private debtors. Eight of the 19 euro zone member countries with high ratings would not face the requirement to set aside equity capital.

A quantitative evaluation on the effects of the proposed regulation shows limitations to large credits would cause significant redeployments in Germany, particularly to public banks, but the capital services requirement would have limited impact. Thus, setting aside proprietary capital alone would not solve the underlying problem.

This increases the costs of state financing, which is why political opposition is expected throughout Europe. In Germany, the proposal also can expect little enthusiasm, especially from banks regulated by public law. But this should not prevent the introduction of new regulations. On the one hand, they are essential for a stable financial architecture in the euro zone. On the other, they would deliver an impetus for reorganizing municipal and state financing while loosening the tight links between individual banks and city and state governments.

Germans cannot demand other countries loosen the connections between states and banks until they address the problem in their own country.

 

To contact the author: gastautor@handelsblatt.com

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