Our modern statist rulers insidiously debase our currencies with their decreed zero-risk weighting of sovereigns

Lawrence W. Reed in “Did You Know about the Great Hyperinflation of the 17th Century?” FEE August 2017, quotes Nicolaus Copernicus (1473–1543) with: “The greatest and most forbidding mistake has to be when a ruler tries to make a profit from the minting of coins by introducing and circulating new coins with an inferior weight and fineness, alongside the originals, and claims that they are of equal value”

And Reed notes: “Desperate to raise cash and secure material for war, many of the German states in 1618 resorted to the debasement of coinage. They clipped and they melted. At first, they adulterated their own coin but then discovered that they could do the same to that of their neighbors too.”

Our modern governments use much more refined and insidious debasement methods. In order they say to make our banks safe, regulators came up with the risk weighted capital requirements which assigned to the sovereign a risk weight of 0%... yes, you read it well, zero percent.

That means that banks are able to leverage any little net margin obtained on public debt, into great returns on equity. That means that banks will be offering to hold a lot of public debt at low rates which will help to confound all the rest of investors into believing the markets believe that debt to be intrinsically safe.

That also means banks are going to absorb much more of the governments injections of liquidity than would otherwise have been the case.

One day buyers of public debts of these by regulators decreed ultra-safe sovereigns, are going to wake up.

When that happens all bets are off. Interest rates on public debt will shoot up, repaying governments will inject liquidity that will be impossible to drain… and economic realities will be hyper-inflation/hyper-recession messy.

When will that happen? Who knows, in Europe governments have already recruited insurance companies to also operate under a scheme similar to the banks’ Basel I, II and III, and which has quite cynically been named Solvency II.

Why is this all unsustainable? Any system, in which government bureaucrats can, without being responsible for its repayment, have easier access to other peoples’ money than for instance the 100% risk weighted SMEs and entrepreneurs, simply cannot end well.

PS. I often hear the argument that if sovereigns borrow in their own currency they represent indeed a zero risk because they will always be able to repay. Wow they’ve got to be kidding! True repayment does only happen when done with purchase power that has not been diluted by inflation.

PS. The confession that shall not be heard: “Assets for which capital requirements were nonexistent, were what had most political support: sovereign credits… A simple ‘leverage ratio’ discouraged holdings of low-return government securities" Paul Volcker 2018

PS. Here is a current summary of why I know the risk weighted capital requirements for banks, is utter and dangerous nonsense.

PS. My 2019 letter to the Financial Stability Board

To obtain loans sovereigns don’t need to threaten lenders with dungeons anymore. They now have the Basel Committee.

In Yuval Noah Harari’s “Sapiens: A brief history of humankind” we read: “The king of Spain desperately needs more money to pay his army. He’s sure that your father has cash to spare. So he brings trumped-up treason charges against your brother. If he doesn’t come up with 20.000 gold coins forthwith, he’ll get cast into a dungeon and rot there until he dies”

Nowadays sovereigns are much more intelligent and much less transparent. They appoint their expert technocrats to the Basel Committee for Banking Supervision and who, for the purpose of setting the risk weighted capital requirements for banks, assign a 100 percent risk weight to the private sector and a zero percent risk weight to the sovereign.

Read more about the horrors of the Basel Accord of 1988, and which no one protested.

If earth suffers an immediate threat to its existence, let us pray bank regulators are not part of our first response team.

In 1988 the Basel Accord (Basel I), for the purpose of determining the capital requirements of banks, introduced the ludicrous out of this world concept of a zero percent weight for the sovereigns and a 100 percent weight for the private sector.

That could only have the effect of banks lending more and in better terms to the sovereign than to that private sector that usually is from which the sovereign gets its strength; and which implied bank regulators thought that government bureaucrats could use bank credit more efficiently than for instance SMEs and entrepreneurs. Unless one is a full-fledged statist or a communist, such a concept should have been totally unacceptable.

Myself, coming from being a corporate financial consultant primarily in Venezuela, had very little to do with bank regulations but, in 2004, when I was just awakening to what the Basel regulations contained, in a letter that was published in the Financial Times I wrote: “We wonder how many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

But now soon 30 years after that initial Basel Accord correcting that zero risk weighting flaw seems finally to have come up on a decision agenda.

In March 2011 the issue appeared at a roundtable of the IMF which concluded with José Viñals, IMF Financial Counselor and Director of Monetary and Capital Markets Department, stating: “The emphasis put by the panelists on issues such as the interconnectedness between sovereigns and banks, regulation and its impact on financial risk, the need for joint and credible sovereign-bank stress testing, debt issuance strategies, and the role of the central banks in mitigating liquidity versus credit risk have clearly demonstrated the need for us to look at sovereign risk in a much broader context of issues and vulnerabilities than we have done so far.” 

And then it pops up in October 2011, in a speech by Hervé Hannoun the Deputy General Manager Bank for International Settlements titled “Sovereign risk in bank regulation and supervision: Where do we stand?” Hannoun, first things first, clears regulators from any responsibility: “market participants’ complacent pricing and accumulation of sovereign risk in the decade up to 2009 was a market led phenomenon that cannot be attributed to the Basel standards.” But then he anyhow opines: “However it becomes crucial for regulators and supervisors of large banks to clarify that although sovereign assets are still a relatively low risk asset class, they should no longer be assigned a zero risk weight and must be subject to a regulatory capital charge differentiated according to their respective credit quality." That said he finally returns to the original sin stating:"A key objective for governments in advanced economies is to earn back the quasi-risk-free status of their debt"

Also the then General Secretary of the Prudential Supervisory Authority of Banque de France, Danièle Nouy in April 2012 wrote: “it appears that current regulatory framework does not require from financial institutions to hold significant regulatory capital against sovereign risk, inadequately assuming sovereign debt as a low-risk and even a risk-free asset class. Furthermore, some regulatory initiatives, while globally enhancing standards, could create further incentives to encourage financial institutions to hold sovereign debt. In addition to considering better reflection of sovereign risk in financial regulation, supervisory practices also appear as a crucial tool to address the issue of heightened sovereign risk and its potential impact on financial stability.” 

And in a speech delivered on May 5, 2015 Stefan Ingves, the current chair of the Basel Committee wrote: “A discussion of the risk-weighted capital framework would not be complete without a discussion of the Committee's work on sovereign risk… the Basel Committee's oversight body - agreed to initiate a review of the existing regulatory treatment of sovereign risk, including potential policy options... I think we can all agree that there is no such thing as a risk-free asset. When we talk about this issue we talk about ‘sovereign-risk’ - not about ‘sovereign risk-free’”

And Jens Weidmann, the President of the Deutsche Bundesbank in a speech on December 10, 2015 titled “A central banker’s take on improving the euro area’s stability” “While bail- outs and monetary financing are prohibited under the Maastricht treaty, sovereign debt is nonetheless treated as risk-free in the capital regime for banks. Danièle Nouy, the chairwoman of the European banking supervision, said: ‘Sovereigns are not risk-free assets. That has been demonstrated, so now we have to react.’ I totally agree with her. Sovereign debt in banks’ balance sheets needs to be backed by capital, just as is the case for any private debtor. But perhaps it is even more important to put a lid on banks’ exposures to a single sovereign.” 

Oh boy, this all sure is in slow motion... in the getting it and in the reacting to it, I can only conclude in that if earth suffered an immediate threat to its existence I sure wish bank regulators are not part of our humans’ first response team.

Of course I wish for the statist/communist favoring of the bank borrowings of the sovereign to disappear but, because of the temporary huge bank capital scarcity that could produce, I must pray it is carried out in such a way that it does not further increase the squeeze on the access to bank credit of those in the private sector perceived as “risky”. They have it hard enough as it is.

And sadly, the current bunch of bank regulators have given us enough evidence they do not understand what banks are for. In fact they have never even defined the purpose of banks before regulating these... and how stupid is not that?

PS. November 2018: In Europe by means of the European Commission’s “Sovereign Debt Privilege”, the risk weight assigned to all Eurozone sovereign debtors is still 0%, this even when that debt is de facto not expressed in a domestic (printable) currency. Oh boy, this all sure is no motion at all.

PS. How would government finances look if house prices had not gone up the last decades?

This is the farmer sowing his corn,
 That kept the cock that crowed in the morn, 
That waked the priest all shaven and shorn,
 That married the man all tattered and torn,
 That kissed the maiden all forlorn, That milked the cow with the crumpled horn,
 That tossed the dog,
 That worried the cat,
 That killed the rat,
 That ate the malt
 That lay in the house that Jack built...That was taxed by the taxman

'

PS. My letter to the Financial Stability Board dated March 2019