To solve the European sovereign debt crisis it is necessary to look beyond the immediate effects of proposed solutions. Since the European Monetary Union is a highly interdependent system, any solution must not only remedy the problem at hand but also improve the working of the system as a whole. Unfortunately, many of the proposed solutions fall short of this requirement.
Instead, they are prone to what is known as the “cobra effect.” The cobra anecdote is set in colonial India. Trying to stop a plague of cobras, the British government offered a bounty for every dead snake. The plan seemed to be working at first. High numbers of dead cobras were presented to the colonial administration. Unfortunately, this did not get the plague under control. Most of the dead cobras were not wild ones – they had been bred by enterprising locals in order to claim the bounty. When the governor finally caught wind of the practice, he scrapped the reward, causing the cobra breeders to set the now worthless snakes free. As a result, the plague was worse than ever.
Every policy not only addresses a problem, but changes the nature of the game as well. This has to be taken into account when evaluating the overall merit of any measure. And when we look beyond instant effects, many policies lose their lustre.
Eurobonds are a case in point. Granted, eurobonds would offer temporary respite to heavily indebted member states of the euro area. But the introduction of eurobonds would throw the already lopsided balance between liability and control even further out of kilter. While spending decisions would essentially remain a national prerogative, liability would become European. Incentives to incur further debt would thus be strengthened, not weakened. This would strain rather than smooth the working of the system.
Instead, what is needed are steps that encourage each part of the system to behave responsibly, while at the same time making the system more robust against failures of its constituent parts.
Severing the overly close link between banks and sovereigns is a crucial example in that regard. The banking union, the Single Resolution Mechanism in particular, goes a long way towards ensuring that taxpayers do not foot the bill in the event of a bank failure. Defining a clear hierarchy of creditors is crucial in that regard. Shareholders and creditors have to be first in line when it comes to bearing banks’ losses. The proposed Bank Recovery and Resolution Directive is a big step forward but the current proposal still allows for discretionary exemptions from bailing in creditors. In the interest of market discipline, this needs to change.
To further strengthen market discipline, the Single Resolution Mechanism will have to ensure that banks without a viable business model can exit the market in an orderly fashion. This would strengthen incentives for effective credit monitoring and would moderate banks’ risk appetites. In so doing, it enhances the allocation of capital and reduces the risk of a bubble emerging.
But the vulnerability works both ways. We also need to make sure that worsening public finances do not infect the financial system. To strengthen the banking union’s immune system, we need to end the preferential treatment for sovereign debt. Sovereign bonds have to be adequately risk-weighted, and exposure to individual sovereign debt should be capped, as is already the case for private debt.
At present, sovereign bonds are treated by European regulators as risk-free – an assumption that stands in contradiction both to the no-bail-out clause and to recent history. An adequate risk weighting of sovereign bonds would make banks more resilient if the fiscal position of the respective sovereign were to deteriorate. And it would bring spreads more into line with the underlying risk, thus giving a disciplining signal to the sovereign.
But sovereign bonds pose a threat to financial stability not only because of preferential risk-weighting. The most important rule in risk management is diversification. Yet when it comes to sovereign bonds, banks all too often neglect this principle. In many cases, European banks hold bonds from one sovereign only – their home country. Large and undiversified exposure is what makes a sovereign systemically relevant. Hence, the large exposure regime which caps the investment in one single debtor has to be applied to sovereigns as well.
Only then will the failure of a part not equal the failure of the system as a whole.
Dr. Andreas Dombret is a member of the Executive Board of the Deutsche Bundesbank