Dangerous Liaisons: How Sovereign Debt Weighs on Eurozone Banks

In the summer of 2012, when the eurozone crisis was breaking bad and Spanish banks were heavily hit by the burst of a real estate bubble, Europe set up a mega-loan to the Spanish government to help out its most-in-need financial institutions. Madrid injected something like 18 billion euros of EU-funded aid into Bankia alone.

At the time, the Nobel Prize-winning economist Joseph Stiglitz thought the plan was unlikely to work because of the deadly embrace between the government and the banks. It was “voodoo economics,” he said, because the helper—the government—was actually financed by the entities it was supposed to help. “The system . . . is the Spanish government bails out Spanish banks, and Spanish banks bail out the Spanish government,” he told me in an interview originally intended as a discussion of his book, “The Price of Inequality: How Today’s Divided Society Endangers Our Future”.

Three years later, it turns out that the plan actually somehow worked. In January, Spain formally exited the 41.3 billion euro loan program funded by its European partners. The country is borrowing at the lowest cost since the eurozone crisis after the government sold 7.5% of Bankia at end of February, which in the meantime is back to profit.

Building on those positive results, two Bank of Italy economists, Paolo Angelini and Giuseppe Grande, write in an April column on Vox that the solution to the “deadly embrace” between banks and government debt is already in the making, at least in Europe. The European Central Bank’s Single Supervisory Mechanism announced in September 2012 and the its Outright Monetary Transactions program have helped stabilize the euro.

“For the Eurozone, the Banking Union project is an essential part of the solution,” they write in the column. “The recent trends in sovereign bond yields demonstrate that efforts to accelerate the process of European integration are finally bearing fruit. They should be continued in earnest.”

They reject as too risky, pro-cyclical and complicated a solution proposed by others that could be more stable in the long run. In most countries, banks accumulated public debt at the time of the crisis because current regulations assign low or zero risk weight to domestic sovereign exposure. A tightening of these rules would therefore likely have the affect of cutting into the holdings of government debt in a steady and direct fashion.

“In our view, the policy option of imposing tighter prudential rules on banks’ sovereign exposures is viable in a steady state, but complex in a crisis situation,” they write. “In the present phase, it could be highly pro-cyclical, as it would risk fuelling instability on government bond and bank funding markets.”