Financial Times
October 10, 2011
Leaders across Europe are struggling this week with the urgent challenge to use the European Financial Stability Facility (EFSF) to stabilise the banking system, strengthen the broader sovereign bond market, and permit orderly default for Greece. Following the forced break-up of the Franco-Belgian bank Dexia, there are increasing calls for recapitalisation of banks and support for sovereign debt across markets. The worry is that the EFSF funds will not stretch that far and additional funds will take too much time. An efficient solution would aim to stabilise the banks by ringfencing the sovereign debt on their balance sheets – making it possible for countries that need to reschedule to do so.
Europe’s leaders are trying to mimic the approaches used in the credit meltdown that followed the collapse of the securitised mortgage market so vivid in memory. In designing a solution to the current crisis, they must instead take advantage of two characteristics of euro-denominated sovereign bonds: the small number of issuers and the special treatment they all receive under banking regulations.
Most important, unimpaired sovereign debt requires no capital from a bank under present rules. Thus, banks could hold this debt to maturity with no impact on their lending capacity, so long as it is serviced. Moreover, bank accounting rules generally differentiate between a trading book, which must be marked to market, and assets which will be held to maturity and need not be marked to reflect the broader market price. These characteristics could underpin a new approach to stabilising the banking system by insulating it from exposure to a small group of sovereign issuers.
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