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EU could break 'doom loop' by rewarding banks that buy other countries' bonds

Banks should be incentivized to buy sovereign bonds from across the bloc to create a diversified but risk-free portfolio to hasten the move toward a banking union, rather than be forced to set aside capital for sovereign bond exposure.

The proposal was outlined at the recent European Central Bank conference on fiscal policy and European Monetary Union governance by Luis Garicano, who is an economist and liberal Spanish member of the European Parliament. It came in response to comments from the German Finance Minister Olaf Scholz on furthering the bloc's banking union plans.

Scholz raised the possibility of ending the zero risk weighting on sovereign bonds as part of a range of measures to speed up moves toward a European banking union. He said he would accept a deposit insurance scheme — or, more precisely, a reinsurance scheme — if there was a further reduction in debt for banks including the risks associated with sovereign debt. Scholz also suggested limits on how many bonds from a single sovereign a bank could hold.

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Excessive holdings of domestic debt by a country's banks is regarded as one of the key reasons behind the eurozone crisis that followed the financial crisis because it created the so-called "doom loop" whereby weak banks and countries drag each other down.

Regulatory incentives

Garicano's suggestion takes Scholz's proposal further and suggests banks should be rewarded, or "regulatorily incentivized," for diversifying their sovereign bond portfolio and that a concentration of domestic bond holding should be targeted.

Garicano proposes that banks should face increases in risk-weighting or "sovereign concentration charges," depending on how far their own EU-wide sovereign portfolio deviate from a "safe portfolio," a term coined by Scholz. The safe portfolio could be based on capital contributions to the ECB by member states — 26% for Germany, 20% for France and so on.

"Assigning a zero percent risk weight to all EU sovereign bonds generates clear market distortions, and indeed is one of the key sources of the sovereign-bank nexus," Garicano wrote. "Given that credit risk, and the subsequent appropriate weights, remain difficult to effectively measure and determine, it is clear that the market distortion should be corrected by targeting concentration risk, shown to be easier to quantify and weight."

The scheme would encourage Italian banks, for instance, to offload Italian government bonds to other European banks, which would be encouraged to diversify away from their own sovereign portfolios.

Garicano's proposal might prove more palatable than Scholz's to countries whose banks have a large exposure to their own sovereign bonds and have repeatedly resisted suggestions for sovereign bonds to carry capital charges.

Italy's banks, for example, have by far the highest exposure to their country's domestic sovereign debt, at 21.68%, compared to Europe's other largest economies — the U.K.'s, for instance, is just 4.33%.

'Eurobonds'

Italy's central bank chief Ignazio Visco has said capital charges on banks' sovereign exposures could be acceptable but only if a "eurobond" — a common eurozone safe asset backed by all eurozone countries — was introduced at the same time, something with which Germany strongly disagrees.

Jean Pierre Mustier, CEO of Italy's UniCredit SpA, told members of the German government before Christmas that German banks would have to buy Italian government securities because they need to diversify their weight and reduce their exposure to German Bunds.

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