Far from being the classic "risk management tool", government bonds today are beginning to look like toxic assets. And bailing out the governments issuing these bonds is tantamount to bailing out the banks - yet again.
European taxpayers are asked to bail out Greece and other southern European countries to avoid a financial meltdown. The logic is that most Greek and other government debt is held by banks, so if we let these countries default the banks will default, so we are back to November 2008. The recent collapse in European bank stocks suggests that markets increasingly believe that German, Dutch and Finnish voters will not agree to this second bank bailout in three years.
European banks are sitting on a mountain of government debt. One has to ask the obvious question: why have they bought so many government bonds? The purpose of a corporation is to issue equity to investors to invest in projects that they cannot invest in on their own. So a bank does not create shareholder value by using shareholder funds to buy Greek bonds, as these shareholders can buy them directly. If a bank pays higher corporate taxes on interest from government bonds than the investor, these types of indirect investments are not tax-efficient.
Regulators force banks to have a minimum Tier 1 capital ratio. This is defined as the ratio of book value of equity divided by risk weighted assets (RWA). Banks are pretty good in meeting this requirement. What is remarkable is the stability of this ratio, which hovers between 8 and 9 per cent during the year. Based on this ratio, one gets the impression there was no financial crisis in 2008. However, market-based leverage ratios and credit default swap rates increased dramatically during this period and reflect the reality that everyone knows: there was indeed a financial crisis in 2008.
Capital regulation based on Tier 1 ratios is ineffective. If regulators want to regulate the capital structure of banks, they should encourage them to manage capital ratios based on market values, not book values. If that was the case today, banks would be busy issuing equity rather than sitting on the sidelines hoping for a bailout that may never happen.
How do banks manage to keep this ratio so stable? The RWA can be lowered by selling risky loans and buying government bonds. European bank capital requirements treat all euro-zone sovereign debt as risk-free. In contrast to US regulators, European regulators ignore the credit ratings of EU bonds. The European bank stress tests last month assumed that government bonds issued by EU members were risk-free, including Greek junk bonds that were trading at large discounts from nominal value.
This contempt for markets and rating agencies is obviously politically driven: European politicians want to promote a united Europe where economic convergence is the rule, and where there is no room for two-tier sovereign debt. The result, however, is that investors were given the impression that the EU would bail out countries when they got into trouble.
This encouraged European banks to invest in Greek bonds, even if their credit spreads were only a few basis points higher than government bonds issued by other EU members. The disappointment of investors that such a bailout may not happen is understandable: the behaviour of regulators implicitly assumed it was more or less guaranteed.
The book value of equity, the numerator of the capital ratio, requires increasing profits, lowering payouts or convincing shareholders to put in more capital. The obvious way to manipulate the denominator is to avoid realising losses. Hanging on to bad investments explains why the book value of a bank's equity significantly overstates its market value. Banks hang on to bad investments, similar to individuals with extreme loss aversion: they believe they have not lost any money as long as they have not sold the asset. So we are now facing a surrealistic scenario: to meet regulatory requirements, banks have invested in and are holding on to Greek, Portuguese, Spanish and Italian bonds.
Now that these investments have gone sour, taxpayers are again asked to bail out the banks indirectly by bailing out these governments. Note the contrast with the previous crisis, which was blamed on the greed of bonus-driven bankers who made excessively risky investments that were too complicated to understand.
This time the trouble comes from being too risk-averse: investing in plain vanilla government bonds that are considered safe because regulators declared they are. So this crisis is not a result of greed or a failure of capitalism. It is the result of failure of government, in particular regulators.
It seems the real problem is governments living beyond their means. Banks buying distressed government bonds appears to be a move to satisfy regulators and help governments stay solvent, but this encourages only government profligacy.
But perhaps there is some hope for change: voters worry about government debt because they realise that eventually they or their children will have to repay it through higher future taxes. Something good may come out of this crisis after all: the nail in the coffin of the theory that government borrowing and spending creates wealth.
* Theo Vermaelen is professor of finance at Insead Business School