What is more, it is chiefly weaker banks – poorly capitalised ones that are highly dependent on capital market funding – which bought up sovereign debt. So if we are looking to offer banks greater protection against distressed public finances, it is government bonds we must target. From the perspective of prudential regulation, there are two factors which play a role here.
The first item regards banks’ capital. Under the current regime, banks do not need to hold capital against the risks of loans to sovereigns – unlike other loans. The thinking here was that sovereign borrowers could not default and that loans to governments were therefore risk-free. And, if no losses could develop, it wasn’t necessary to establish capital buffers.