One of the most vexing questions facing financial markets this year is why trillions in central-bank quantitative easing is stymied by negative interest rates. These unprecedented rates pose tremendous market risk even as they contribute to deflationary pressures that stoke macroeconomic danger. Why are central bankers trying so hard and getting so little? One answer, I believe, is the perverse result of a rule they wrote: a zero risk weighting setting the capital requirements for sovereign obligations.
The reason zero risk weights are so wrong for sovereign bonds is simple: Sovereign bonds have a lot more risk than captured by a nil capital charge. Although leverage capital standards – yet to be imposed in the Eurozone – try to offset this, the leverage-capital standards do nothing to offset the fundamental incentive to hold zero risk weighted assets. No matter the leverage requirements, zero weights give banks a place to park funds and make at least a bit of a buck without hiking the capital ratios with which most are already having a heck of a time complying. Leverage rules crimp sovereign holdings banks used to keep around for clients – hence the market liquidity squeeze I assessed last week – but the sovereigns banks hold for their own needs are nonetheless gigantic.
The purpose of QE is for central banks to buy sovereigns and similar assets from financial markets so that financial institutions don’t hide in the low-risk weeds and instead are forced to venture into lending that would boost economic recovery. But, because banks have to hold huge books of sovereigns, the actual effect of QE is to create bidding wars in which central banks and their charges go toe-to-toe in fixed-income markets. Banks usually lose, which hikes their cost to levels many in the market deem irrational – i.e., current negative interest rates on the highest-quality sovereign paper that most banks most want.
The adverse effect of the current capital framework is exacerbated when external economic factors combine with it to create even greater demand for high-quality sovereigns. This is the case now as geopolitical risk and occasional near-death market melt-downs cause financial markets into “flights to quality” that make sovereigns even scarcer and, thus, more dear. Add in commodity-price deflation, and the drive to safe havens becomes even more determined.
The only exception to this flight to quality results from the perverse interaction of the zero risk weighting for sovereigns and the leverage rule. In desperate efforts to make return-on-equity work out at least sort of right, banks are forced to balance their huge books of negative-return sovereigns with higher-risk assets, especially higher-risk ones not scored properly under the current risk-based capital standards.
This capital arbitrage is in full swing – see the leverage-lending market as a case in point. It thus not only stokes pockets of significant risk on bank balance sheets, but also fuels still greater volatility in broader financial markets. Yield-chasing almost never comes to a good end, but the prospects for calamity are all the greater when yield-chasing is ginned up by regulatory, not economic, forces.
Basel has finally cottoned to the fact that a zero risk weight for sovereigns might not be such a hot idea. It reiterated earlier this week that thinking about this is on the to-do list. Read the language here, though, and it’s clear that Basel will move very slowly – if at all – to revamp its risk weightings. The reason: sovereign governments, especially those in the Eurozone and Japan, are entwined with their banks in a desperate bargain to pretend obligations are risk-free so they can issue all the more of them to fund government spending.
This bondage has often been called the “doom loop” and it was a cause of the Eurozone systemic collapse due to the inability of banks to save their states or of states to save their banks. Now, though, central banks are hand-cuffed in concert with their governments. The more sovereigns they buy, the greater the risk that rates will go still more deeply negative because banks just have to have these same obligations for the reasons I’ve outlined above. This doom loop is different than the financial-market linkage – it comes from bidding wars that create vortexes of sovereign-bank scarcity, but it’s just as dangerous if not more so.