The Political Economist

After the initial identification of the causes of eurozone contagion in domestic and foreign instabilities, having in mind the current debt situation we now look at how and why the banks got incorporated into the peripheral contagion, which led to further systemic risk, and finally, how did the collapse take place after a sudden credit stop. How the banks got caught up buying peripheral debt? As was already noted in this blog, eurozone banks were buying the peripheral debt as part of their zero risk-weighted assets. While the regulatory requirement on holding a corporate loan was 8%, the capital requirement for holding sovereign debt was just 1,6% (sovereign debt, considered to be a zero risk asset was given a 20% risk-weight, resulting in the total 1,6% of capital requirement for sovereign bond holdings). This meant that if a bank was to lend to sovereigns instead of businesses it could make much more money (leverage on sovereign bonds was 62.5 to one compared to leverage on busi...

Note: this blog post was also published at the Adam Smith Institute blog titled: "The paradox of regulation" Apart from the policymakers in the EU summit, the regulators across Europe are designing their reform proposals on how to improve the financial system and make it more robust to future crises. One of the main proposals on banking regulations in Europe is done by the Basel Committee on Banking Supervision . In addition to Basel I and Basel II, the previous banking reforms that substantially influenced the changes in banking regulation worldwide (I briefly touch upon the Basel Accords in my paper on the crisis ) the new proposal, Basel III goes a step further. It is seen as a comprehensive response of the Basel Committee to the financial crisis of 2007-2009.   The Basel III agenda  is based around three key elements aimed at making banks more resilient to future instabilities. Banks need to have core tier one capital equal to 7% of their risk-weighted assets; top “s...