Sovereign Debt and Banks: The Bhidé/Phelps Recommendation

Introduction

We hear daily of a new Euro crisis. Almost invariably, the crisis is linked to banks. One might even conclude there is more concern over the welfare of banks than the welfare of citizens when Euro countries are forced to enter into austerity programs enforced by the IMF.

Amar Bhidé and Edmund S. Phelps, on faculties at Tufts and Columbia universities respectively, have recommended that banks not be allowed to buy sovereign debt (“The Root of All Sovereign-Debt Crises”). They argue that such purchases are too risky for banks, and that they are at the root of all sovereign debt crises. I don’t buy it. Read on.

Their Argument

Bhidé and Phelps (B/P) start by making an interesting point: “Lending to foreign governments is in many ways inherently riskier than unsecured private debt or junk bonds.” Typically, there is no collateral for sovereign debt, only “the full faith and credit”…. And as B/P point out: “Only governments that are chronically unable to finance their outlays with domestic taxes or domestic debt must keep borrowing large sums abroad.” Borrower incentives are also different: private borrowers can end up in jail for misrepresentation. And bankruptcy proceedings give all creditors a chance to recover at least part of their loans. None of this applies to sovereign debt: no one person can be put in jail for misrepresentation, and there is no bankruptcy process for this sort of debt.

B/P conclude: “Lending to states thus involves unfathomable risks that ought to be borne by specialized players who are willing to live with the consequences…. The solution to breaking the nexus between sovereign-debt crises and banking crises is straightforward: limit banks to lending where evaluation of borrowers’ willingness and ability to repay isn’t a great leap in the dark. This means no cross-border sovereign debt (or esoteric instruments, such as collateralized debt obligations).”

What Is Wrong With Their Argument

There are several problems with their arguments:

  • They are arguing for the most severe form of market interference – banning a purchase of something; history tells us that such interference rarely works and should be a last resort.
  • B/P make it sound like buying government debt is somehow very complex. They talk of “unfathomable risks” and “a great leap in the dark”. What? Excellent information on the economic/financial condition of governments is available from private and public sources (my favorite source is the staff reports coming from IMF Article IV country consultations).
  • Even before the bank collapse in 2008, a cursory examination of the financial condition of the Greek government would suggest that buying its debt would be a very risky proposition.
  • I quote from an IMF report included in an earlier piece: “Banks in Greece, Ireland and Portugal have significantly increased their government debt exposure during 2010. Shunned by financial markets and faced with deposit withdrawals, they survive only because the ECB meets in full their demands for liquidity against collateral of rapidly declining quality”. The real question is: why did banks provide a ready market for new Greek and other troubled Euro country debt when such high risks were so apparent?

Why Banks Bought High-Risk Sovereign Debt

I have addressed this at length in earlier articles. In sum, banks see high returns on Greek debt. Banks like high returns, but they don’t like risks. What do they say to their risk officers?  Bank A says we will buy risk insurance from Bank B. Bank B says we will buy risk insurance from Bank A. Alternatively, the banks will accumulate Greek debt, package it, and sell it off for a commission.

What is going on here? Depository institutions have evolved into high risk trading operations. Consider their incentive structures against those of banks that manage their own loans:

  • Banks that manage their own loans know their very survival depends on the spread between what they have to pay to get deposits and what they get paid for loans. As a consequence, they don’t make risky loans: no “unfathomable risks” or “great leaps in the dark”;
  • The troubled European banks, like the US banks that caused the 2008 collapse, are very different animals. They earn significant sums from trading. Risk? No problem. We can get risk insurance or package the loans and sell them off for a nice commission.

The Morss Solution

Why are we worried about banks? Because they hold deposits and governments want to be sure the deposits are safe. If they do not hold deposits, who cares? Let them go belly-up. As a consequence my solution is very simple – limit government deposit insurance to banks that do very little trading and manage their own loans.

The content above was saved on the old Morss Global Finance website, just in case anyone was looking for it (with the help of archive.org):
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