Keep in mind, Greece is not being bailed out. Greece's bondholders are being bailed out. Greece would rather default. Cleared of its debts, it would likely be able to borrow again soon.
One would think that wise regulators would have required hefty capital against sovereign lending, or lending to other banks whose main investments are Greek debt. One would think that given a full year, those regulators would have at least increased the capital requirements for sovereign debt, run serious stress tests against sovereign default, or forced banks to buy credit-default swap insurance from counterparties other than Greek banks. But one would be wrong. (This is a sobering lesson for the U.S.'s plan under Dodd-Frank to trust that our wise regulators will spot all dangers, require adequate capital, and keep banks from getting into trouble.)
Third, the European Central Bank (ECB) is now involved as well. It started buying secondary-market Greek debt last May. The ECB has now lent in excess of 80 billion euros to Greek banks, replacing private funding that has run away, and typically receiving Greek government debt as collateral.
Under Basel II in December 2009, Greek government bonds, rated A-/A2, had the same 20 percent risk weight as AA/AAA asset-backed securities in the United States. It seemed like easy money, and banks levered it up. As usual, regulations did not alleviate the problem, rather, they encouraged it.
It occurs to me that there are two problems with your thinking here:
1. Those particular regulations may have "encouraged" the problem, but you generalize to regulations in general. Couldn't it possibly be that there exists a set of regulations that would not have encouraged it, and that would have discouraged the problem?
2. If your preferred alternative to regulation is the market, did the market fare any better here? After all, as Cochrane and Kashyap say, it is the bondholders, not the sovereign, that require a bailout. Why didn't the bondholders require "hefty capital against sovereign lending"?
There really is no answer to your first question. There always COULD be a possible regulator that would have done a good job. It is an empirical question as to whether such regulators are likely to exist in the wild given the incentives that politicians and regulators operate under.
But to the second question, the bond holders assumed that they would be bailed out so the would not need hefty capital and it looks like they were right. So it looks like the market was pretty rational.
Not necessarily going to disagree, but I would add:
One thing that constrains regulators in addition to their systemic incentives, etc. and the influence of the regulated are arguments like Eric's here. If half the electorate bleets "regulations are bad," then it's less likely that regulation will ever be sufficient, because it will tend to being too small.
Also, on the second point, market participants betting on bailouts may have been rational but they were suboptimal societally. Further, the expectation of bailout does not mean the problem was the regulators' fault by classifying the sovereign debt as similar to AA/AAA ABS in the US, as Eric claims.
I have sympathy for you folks in the US trying to work this one out. Its like watching a family argument. You can understand the words being said, but don't understand what the participants mean.
Its important to remember that for European politicians, the economy is a means to an end, not an end in itself. The issue is, given that fighting for dominance in Europe turned Europe into a mass graveyard twice in the last century, how does Europe sort out political dominance peacefully.
As a British Eurosceptic, I've always viewed the Euro as a Franco-German plot to rule Europe. Did you notice the German protests at Ireland's wish for a low corporation tax? How is Ireland ever to pay off its debt without competitive advantage? The Franco/German axis wants to eliminate all competitive advantage in outlying countries to move power to the centre. Ireland will be condemned to permanent indebtedness to Franco/Germany.
So this isn't about the state of Greece's economy, or any other economy. Its about how much Franco-Germany is prepared to pay to other European countries to have the benefits of being the effective rulers of Europe. There will be a settlement. Its just a question of waiting for the German population to accept that they have to write a very large cheque if they want their political dreams to come true.
A default doesn't stop the pain because it forces a balanced budget. The peripheral countries need to leave the Euro to restore their freedom of action. Countries with their own currency never need to suffer a depression, since the government can always, as a last resort, eliminate unemployment by directly hiring people.
Europe: Exposures to Member States' central governments and central banks denominated and funded in the domestic currency of that central government and central bank shall be assigned a risk weight of 0 % (i.e the rating doesn't matter)
Mahalanobis: Is that the current risk weighting for Greek debt? I thought it varied if the rating was low (<AA).
Eric: Yes. This is written in Directive 2006/48/EG on page 81 (http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2006:177:0001:0200:EN:PDF). I was told by a legal expert that although it applies to banks using the standardised approach you can still apply for valuing certain stuff according to the standardised approach even when you are an IRB-bank.
On my desk I have latest version of the Austrian Banking Act + decrees (i.e. the implementation of the directive) and it says the same [§4 (4) SolvaV].
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