In the EMU context, the “no bail-out” clause of the Treaty should encourage financial markets to distinguish between more and less risky sovereign issues. But other institutional features may work in the opposite direction.
Among these features the favourable treatment of government debt under the new Basel rules as well as regulations which require pension funds to invest a large share of their portfolios in “safe” assets may buttress demand for government paper, putting downward pressure on bond yields. There may, perhaps, be scope for institutional designs that encourage more market discipline.