Saturday, June 15, 2013

Eurozone Banks Hold Too Much Of Their Domestic Sovereign Debt

Banks are encouraged to hold sovereign debt because they do not have to reserve capital against sovereign debt which is deemed to be risk free.  Banks in Europe hold a large share of the debt issued by their sovereign.  Many of the banks would be insolvent is they suffered a loss of only 8% on the sovereign debt that they hold.  This is not true in the US.  Domestic banks hold a relatively modest share of US public debt.  Perhaps that is one of the reasons why US banks issued so many mortgage backed securities which were rated AAA.  They used those bonds as collateral for short term debt that they got in the wholesale market.  There was a run on many of the investment banks when they could no longer use the mortgage securities to turn over their debt.  The general problem in the banking industry is that banks have a financial incentive to leverage their capital.

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