The EU’s Rules to Default By

Greece’s troubles with its ballooning public debt are again throwing Europe’s financial markets into turmoil, because the entire regulatory framework for the financial system was built on the assumption that government debt is risk-free. We now know that it is not, though EU regulators are still encouraging banks to take on as much of it as they want.

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.

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