Implications of Sovereign Debt Default

With recent events, it seems like Basel III is not doing much to prevent another financial meltdown. To share a bit of background first, banks must hold capital depending on the risk-weights: the higher the risk-weights, the more capital banks are required to hold. For example, mortgage-backed securities had low risk-weights and consequently, there’s an incentive for banks to invest more in these assets for higher return on capital. As we all know, arguably the largest global financial crisis unfolded because of these assets.

With the unfolding of the previous crisis, Basel III was discussed for a long time and they came up with many new things, a lot of them sounds like they protect the financial system very well: taking care of short term funding, long term funding and increasing capital requirements. Reading in between the lines and looking at recent events, I am starting to find that we are really struggling to cope with a stable financial system.

First of all, for capital requirements, sovereign debt is assigned 0 risk-weights, including the recently troubled economies Italy and Greece. As banks pay to receive funding, they try ways and means to ensure that they get returns from their funds. Banks make money by getting deposits and making different kinds of loans to consumers and corporations. This seems to make sense, since most will repay and some will default, but the large numbers make it statistically difficult for all to default at the same time. To protect against banks failing, capital requirements were imposed/ tightened and there is also the liquidity coverage ratio (liquid assets over outgoing cashflows in the next 30 days) to ensure that banks can meet their short term funding needs.

This sounds good so far, since we are basically ensuring that banks will keep enough capital to ensure that they can address all outgoing cashflows for 30 days and by then, they should be able to sell off some assets to ensure capital requirements are met. I think there’s a potential issue with how liquid assets are defined in the liquidity coverage ratio though, since it regards sovereign debt as ‘liquid assets’.

The problem is that recent news are all talking about potential sovereign debt default. See the danger? There is an acceptance within the current financial system that sovereign debt is risk-free, but is that really the case going forward? If sovereign debt fails, won’t a lot of banks suffer great losses since a lot of their ‘capital’ is in sovereign debt? Additionally, they may also suffer from short term liquidity issues when that happens because of the way liquidity coverage ratio is constructed. Every bank down affects their counterparties and can easily send another shockwave through the financial system.

Will that come true? I have no idea… For now, I just hope that no sovereign default will be happening, cause I cannot imagine the implications.