EU Sovereign Debt is Not Risk-Free

As the Euro-zone crisis deepens the EU is preparing to tighten Eurozone banking regulations while ignoring a critical area: Eurozone sovereign debt. This, argues Daniel Gros, should be weighted for risk in the same way as any other debt.

General government consolidated gross debt. US...

General government consolidated gross debt (Image Wikipedia)

The EU’s Rules to Default By

Daniel Gros

Daniel Gros is Director of the Centre for European Policy Studies.

“BRUSSELS – Greece’s ballooning public debt is again throwing Europe’s financial markets into turmoil. But why should a debt default by the government of a small, peripheral economy – one which accounts for less than 3% of eurozone GDP – be so significant?

The answer is simple: the financial system’s entire regulatory framework was built on the assumption that government debt is risk-free. Any sovereign default in Europe would shatter this cornerstone of financial regulation, and thus would have profound consequences.

This is particularly visible in the banking sector. Internationally agreed rules stipulate that banks must create capital reserves commensurate to the risks that they take when they invest depositors’ savings. But when banks lend to their own government, or hold its bonds, they are not required to create any additional reserves, because it is assumed that government debt is risk-free. After all, a government can always pay in its own currency…”

(Extract reprinted with permission. To read the full story follow this hyperlink)

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