In the aftermath of the 2008 global economic crisis, governments around the world have adopted new capitalization requirements for financial institutions. Known as Basel III, these regulations have been sold as a way to strengthen shock absorption in the banking industry, to improve its risk management and enhance transparency.

However, as is the case with most government regulations, Basel III comes with unintended, and potentially harmful, consequences. At the heart of the problem is the new structure of capitalization requirements that give strong preferential treatment to government debt – to some extent without adequate appreciation of the quality of its credit rating.

The core of the problem is that financial institutions do not need to set aside the same amount of capital in purchasing bonds from governments as they do for buying private equity. The lower capitalization rates apply to government bonds generally with at least AA- rating.

The big can of worms is opened by the proviso saying that banks can buy domestic-government debt at any credit rating, with less own capital than if they buy prime-credit private equity.

On the face of it, this does not seem to be a problem. Historically, government bonds have been a very safe low-risk anchor for any investment strategy; if the Basel III requirements had been introduced in, say, the 1990s, they would not have been cause for concern.

However, given the experience from the crisis that broke out in 2008, they put these regulations in a new light.

Starting in 2009, banks experienced dwindling loan demand from non-financial businesses. Default risks increased (as is always the case during a recession), growing the need for low-risk government bonds. However, Europe’s treasury bond market offered a narrowing window of low-risk opportunities. A growing share was drifting into high-risk waters, with numerous credit downgrades across Europe. Financial institutions increased their ownership of downgraded government debt by 55 percent in a four-year period, 2009-2013.

  • In April 2009, Moody’s put the Irish government on downgrade watch, executing the first of a total of five downgrades three months later. That same year, the Irish government added 24.6 billion euros to its debt, and financial institutions bought 78 percent of that new debt.
  • In 2010, when Fitch added two Irish downgrades to those by Moody’s, the Dublin government borrowed 39.5 billion euros. Financial institutions purchased 59 percent of it.
  • By 2011, when Standard & Poor’s put Ireland on yet another downgrade watch, financial institutions stabilized their ownership of Irish debt. However, the pattern from Ireland was repeated in Spain. In June 2010, Moody’s put Spain on downgrade watch. In the following two years they downgraded the Spanish government’s credit rating five times. During that time the Spanish government borrowed 323 billion euros, of which financial institutions picked up 71 percent.
  • This amount, 230 billion euros, was more than three times as much as financial institutions had invested in Spanish debt over the seven years preceding 2009.
  • Portugal went on Moody’s downgrade watch in May 2010, followed by a downgrade in July that year. Another four downgrades took place in the following 18 months. Despite its declining credit rating, in 2010-2012 the government in Lisbon was able to borrow another 64 billion euros. Financial institutions bought 55 percent of the new debt.
  • Italy was put on downgrade watch in June 2011. In the following 12 months the country was hit by three downgrades; while Italy’s credit went into a tailspin, financial institutions purchased 203.5 billion euros worth of Italian government debt – 66 billion euros more than what the government needed to borrow.

In four of the five most credit-challenged countries in Europe, financial institutions bought massive amounts of Treasury bonds right as the crisis escalated. It is important to note, though, that this level of data is not available for Greece, the most troubled government in Europe. What is well known, though, is the Greek debt write-off in 2012, when investors lost one quarter of their money with the stroke of a pen.

Purchases of weak-credit government debt were not limited to Ireland, Portugal, Spain, Italy and Greece. France lost its AAA rating with Standard & Poor’s in January 2012. In November that year, Moody’s downgraded France, followed by Fitch in July of 2013 and yet another downgrade by S&P in November 2013. In 2010-2012, the French government borrowed 341 billion euros, of which financial institutions bought 44 percent, or 150 billion euros.

But not only that: The financial-institution share of the debt purchases actually accelerated as France came closer to a downgrade. They bought:

  • 16.3 percent of new French debt in 2010,
  • 45.6 percent in 2011, and
  • 66.5 percent in 2012.

Other countries downgraded by Standard & Poor’s at that time were Austria, Cyprus, Malta, Slovakia and Slovenia.

The investments in downgraded government debt reviewed here took place before the Basel III requirements went into effect. It is relevant to ask how much more debt from these governments that banks would have bought had Basel III been in place in 2008.

This is not just a hypothetical question. A new economic crisis will come, and it will lead to major expansions in government debt. Among the governments that will increase borrowing are the ones mentioned here, most of which have not recovered their credit rating. This means that Treasury bonds with AA- or higher credit are more scarce now, relatively speaking, than before 2008. Therefore, in response to the capitalization bias in Basel III, financial institutions will prioritize domestic government debt, even if its credit is rated far below AAA.

The obvious question is what will happen to banks with major investments in low-credit domestic government debt. While government defaults are rare, the Greek debt write-down has opened possible future losses to bank portfolios that were unthinkable only 10-15 years ago.

Two factors exacerbate the problem. The first one is the “flip side” of the domestic debt incentive. While constructed to motivate banks to buy domestic public debt, it also reinforces the incentive to governments to use deficits as a permanent method for funding spending.

Since they know that their domestic banks are skewed – by government regulations – to buy up their debt regardless of credit status, they are much less inclined to restrain spending. At least in theory, this could lead to a situation where governments calculate on deficits as a permanent source of funding spending.

Secondly, the Basel III capitalization regulations could lead to the perpetuation of risky monetary policy. During the economic crisis, European monetary policy became focused on quantity management, supplying low-cost loans to financial institutions in return for investments in downgraded government debt. This led financial institutions to abandon risk aversion for risk neutrality. Over a longer period of time, lax monetary policy over-supplies the economy with liquidity, perpetuates low-to-negative interest rates and, in addition to neutralizing government-debt risk, leads to excessive liquidity supply to financial and real estate markets.

In conclusion, the effects of Basel III regulations of bond investments could be a destabilization of the very financial system the regulations are created to stabilize. Consistent with Austrian economic theory, over-supply of liquidity leads to asset-price spirals and investment patterns that are inconsistent with real economic activity and underlying consumer preferences. If we add to this the neutralization of risk assessment of government spending, there is a strong case for a destabilization of multiple national economies in Europe, not limited to the financial system. With governments being able to spend on borrowed money, impervious to their credit rating, the negative macroeconomic effects of government spending will add to a destabilized financial system.

Much of this reasoning remains theoretical as the combined effects of Basel III have never been tried before in a real-life economy. However, evidence from the latest economic crisis, economic theory and prevailing negative experience of long-term growth in government spending all, in isolation, suggest that the combination of the three presents the industrialized world with a potentially catastrophic scenario for the next economic crisis.