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Banking regulation IW News 1. April 2015

Disadvantages for corporate credit should be removed

The president of the Supervisory Council at the European Central Bank (ECB), Danièle Nouy, calls for capital adequacy requirements for sovereign bonds. Moreover, she demands an upper limit for these investments. Both reforms were already proposed in recent studies from the Cologne Institute for Economic Research (IW). Privileging sovereign debt by regulation, indeed, disadvantages the credit supply to non-financial firms and enhances financial market risks.

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When banks supply loans to non-financial firms and households or purchase corporate bonds, they have to finance these exposures with a mandatory minimum fraction of own funds. It’s a simple rule: the higher the risk exposure the more bank capital has to be used for funding. Moreover, banks’ credit exposures to firms are constraint by an upper limit on large credit exposures – banks are not allowed to lend more to a single borrower than one fourth of their bank capital. This regulation should ensure that a bank will not come into distress when one single borrower defaults.

Eurozone sovereign bonds, however, can be purchased without using own funds, since the capital requirements regulation regards these exposures as nearly risk-free - a misleading assumption. As a consequence, banks’ balance sheets got worse during the Eurozone sovereign debt crisis, since they held to little capital to absorb losses from depreciating sovereign bonds. Banks were, moreover, overexposed to sovereigns like Greece, Italy, Portugal and Spain. An upper limit on large sovereign credit exposures – as mandatory for exposures to corporates – could have limit banks losses during the crisis.

Most recently, capital adequacy requirements for sovereign bonds gained in importance: While the loans supplied to non-financial corporations dropped by 4 percent per year during the last two years, exposures to Eurozone sovereign debt increased by 8 percent per year.

Moreover, it is problematic in this context, that funds that are borrowed to sovereigns result in a lack of funds supplied to non-financial corporations. Firms in the crisis countries, in particular, are recently challenged with a restrictive bank credit policy.

Capital adequacy requirements for sovereign bonds are, however, unpopular among European politicians. The reason is that under the current bank regulation a huge demand for sovereign bond exists, which allows sovereigns to borrow from banks cheaply.

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