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Doom loop: Europe may be next likely candidate

Is Europe the most likely candidate for the next Lehman Brothers movement?

In some ways, the regulatory response that followed in the years after the collapse of Lehman Brothers has been a success.

The days of racy balance sheets chasing outsized profits on wafer thin capital are largely over. They were replaced by a mantra of prudence and bread-and-butter lending to the real economy.

But one large part of the regulatory puzzle was never completed and that is worrying. Many of Europe’s banks are still susceptible to a fatal flaw that was exposed when the continent lurched into its own crisis.

But one large part of the regulatory puzzle was never completed and that is worrying. Many of Europe’s banks are still susceptible to a fatal flaw that was exposed when the continent lurched into its own crisis.

The European sovereign debt crisis began with the collapse of the Greek economy and its banks and spread to Italy, Spain, Ireland and Portugal. At its center was a dangerous link between the fate of some sovereign nations and their domestic banks. The borrowing costs of weak countries and their weak banks moved in tandem and dragged both down in a “doom loop” towards insolvency.

In May, Italy proved, as if it were needed, that the doom loop appears to remain in place. The borrowing costs of Italian banks and the sovereign spiked in tandem on fears of what the country’s populist politicians might do next. Italian banks own around 40% of all the country’s sovereign bonds. The borrowing costs of the two continue to move in tandem.

The simplest solution to breaking the doom loop would be to increase the cost, through higher capital requirements, for domestic banks to hold their sovereign bonds or impose more stringent exposure limits. This would involve increasing the capital requirements that banks need to hold against sovereign exposures to protect balance sheets in times of sovereign crises.

Doing so would force European banks to rethink the absolute size of their sovereign debt exposures and the concentration to any single individual. Conversely, it may also encourage them to hold a diverse set of sovereign bonds so they are better able to withstand sharp movements in the yields of any one country’s bonds.

It will not be easy to achieve. Working out the capital charge would not be easy because of how sovereign risk is perceived. In normal times, investors barely notice it. In times of stress, they panic. No cost seems to reflect their rapidly changing perception of risk. This is one reason why the doom loop is so pernicious. Investors are relaxed about sovereign debt until they’re not, and then they are panicked.

Many of the region’s banks do not have ready access to the necessary capital, which means they would need to raise it. This could mean reducing their sovereign bond portfolio. While this would ultimately lower their exposures and potentially be a good thing, a rush of banks selling their sovereign holdings would risk a fire sale and instability in bond markets.

Then there’s the question of who would buy the bonds. The European Central Bank (ECB), by far the largest purchaser of European sovereign bonds, is stepping back from the market as it draws its quantitative easing (QE) program to a close.

Giving banks time to meet the new requirements would certainly help mitigate these short-term risks. These transition periods need to be well thought through. If they’re too short, then markets will immediately start pricing in the new capital requirements. But the Basel authorities have shown that they can work if calibrated appropriately.

The overall aim of increasing capital charges for sovereign exposures is certainly possible. Belgium was the first European country to apply a risk weighting for sovereign bonds back in 2014. It led to an increase in risk weighted assets of €4.4 billion ($5.1 billion) at Belgium’s largest bank KBC.

Sweden introduced its own legislation that required its banks to apply a risk weighting to sovereign and municipality exposures in 2017. It added around 9 billion Swedish krona to the risk-weighted assets of SEB, one of Sweden’s larger banks.

Ultimately, attempts to break the doom loop have fallen foul of political differences rather than practical challenges.

Europe’s Banking Union was supposed to end the doom loop and prevent a re-run of the sovereign debt crisis.

But it has been mired in disagreement about how risks in Europe should be shared amongst its members, and it remains incomplete. That should be of concern as populism continues its slow creep across Europe, and Italy has shown how quickly a populist political lurch can bring the doom loop into view. To prevent the next “Lehman moment,” it’s careful to keep an eye on Europe.

Important Information

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

A version of this article was originally published in Financial News on September 3, 2018.

ID: US-170918-72594-1