03 November 2011

Gillian Tett: Subprime moment looms for ‘risk-free’ sovereign debt - Pillar of the regulatory structure looks wobbly

In her FT column, Tett writes that when future financial historians look back at the early 21st century, they may wonder why anybody ever thought it was a good idea to repackage subprime securities into triple A bonds. So, too, in relation to assumptions about the “risk-free” status of western sovereign debt.

As the turmoil in the eurozone spreads, forcing a paradigm shift for investors, the intriguing question now is whether we are on the verge of a paradigm shift in the regulatory and central bank world, too. After all, it is not just investors who have tended to assume that mainstream sovereign bonds are risk-free; this assumption has also acted as a pillar of the entire regulatory structure, and many central bank operations.

But as Greek woes mount, there are now some hints that we may be on the edge of a paradigm shift. One straw in the wind can be seen in recent comments from Sharon Bowles, head of the monetary committee at the European parliament, who is now urging regulators to remove the risk-free sovereign tag, not just in relation to reserves (ie for any holdings of Greek bonds, say, or loans) but for counterparty risk in trading deals, too.

If ideas gather pace (BIS/Hannoun speech - view), they could have big implications in the longer term. For one thing, more realistic assessments of sovereign risk would probably force the banks to hold more capital, and raise sovereign borrowing costs. The other 800lb – or $500,000bn – gorilla in the room is the derivatives market. Until now, sovereign entities have generally not posted collateral for derivatives deals, partly because of that risk-free tag. But Manmohan Singh, an economist at the IMF, believes that this anomaly has helped to create a severe under-collateralisation problem, worth $1,500 billion - $2000 billion for the 10 largest banks alone. If “true” counterparty risk were ever recognised in derivatives, in other words, the implications could be brutal (not least because there may simply not be enough decent collateral to go around, or enough room for manoeuvre by state entities.)

Of course, regulators understand this. Thus, I don’t expect Hannoun’s appeal to be heeded too widely, too soon. It is one thing for European regulators to make banks write off Greek bonds; it is another to reshape the entire rules of modern finance. But the more contagion spreads across Europe’s sovereign debt market, the more pressures will rise for a longer term rethink of that zero-risk label.

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