Sunday, February 21, 2010

Why European banks hold so much Greek government debt

The Basel II concept leads to a false sense of security

European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds. Why do they hold so much Greek government debt? Because the only category of bank asset treated more kindly by the Basel rules than asset-backed securities is government debt, which has a zero risk weight. i.e., no bank capital need be used to buy a government bond. This appears to be the reason that the possibility of Greek default has led to fears of another banking crisis. Digging deeper, the Basel rules rank debt according to the issuer's credit rating. Yet again the big ratings agencies are to blame. It's time to remove their regulatory role.

Posted by drewster @ 02:41 PM (1969 views)
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4 thoughts on “Why European banks hold so much Greek government debt

  • mark wadsworth says:

    These rules on how banks have to value particular things are quite terrifyingly primitive and stupid. I’ve seen a Bank of England return that banks have to complete weekly and send to the BoE and there are standard write downs to be applied to everything – some clearly too high, some clearly too low. It is more or less inevitable that banks will tend to buy stuff where the standard write down is too low (like Greek bonds, in this example).

    I know that Basel rules are probably different to BoE rules, but surely no asset can be marked at 100%, except perhaps coins and notes in your own currency – and even those can be stolen or burned or turn out to be forgeries.

    The unintended consequences of demanding a too severe write down are far less dangerous than overvaluing them (it would merely force banks to reduce their leverage, which with hindsight would have been a very good thing), so it might make more sense to simply demand a 25% write down of ALL assets (or 20%, or 15% or whatever).

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  • The longer this crisis runs the flakier the whole financial system seems to be, the foundations are pretty shallow and the structure itself is evidently unable to support itself without propping up. I’m beginning to understand the Greg Pytel inverted pyramid idea of the system now.

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  • stillthinking says:

    Wow, they made even more bad loans than previously thought. I wonder what the rest of 2010 will bring. So if Greece defaults all our banks are bust (again). Banks look pretty bust whichever way you look.

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  • Mark,

    I think it makes sense to treat sovereign debt as equivalent to cash (i.e. marked at 100%). The UK and the USA can theoretically never default on their debt, because they can always choose to print more currency to repay the debt.

    The mistake with Greece was to treat euro-denominated debt as sovereign debt – which it isn’t. For the Greek government, the debt might as well be in dollars; since they are unable to print euros to repay the debt. This seems patently obvious now; was it not also obvious ten years ago when the single currency was launched?

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