Various regulatory pronouncements define operational risk as that resulting in part from “natural or manmade disasters.” We suggest a rewrite: “natural or manmade disasters, including those spawned by the U.S. Congress.” Bankers will again spend a weekend behind tightly-closed doors figuring out how to mitigate a risk wholly not of their making due to the ongoing debt-ceiling imbroglio. Although the finale to this tragic-comic opera is unknown as we write, one lesson germane to all the regulatory battles is clear: financial markets are not risk-free and, no matter how hard regulators bang on bankers, the industry can’t make it so.

Reflecting the widespread and, to be sure, understandable view that the financial crisis was caused by evil-doing bankers, policy since then has principally been premised on demands that large banks pay for their sins. Two obvious examples are the Basel III capital and liquidity rules which, bolstered by systemic surcharge demands, take a big bite out of the industry’s hide. Some of this is deserved, but the complexity of these rules cover up a continuing serious flaw: both the capital and liquidity standards remain premised on one untrue proposition: that sovereign debt is risk-free.

The invincibility of sovereign debt isn’t just dubious, it’s laughable in the EU, where major national issuers are suffering from acute solvency woes only barely managed through the most recent bail-out. And, now, we’ve learned it also isn’t true regarding liquidity risk. Even though nothing Congress can do – at least so far – dents U.S. credit-worthiness, the chaos surrounding the debt ceiling has put significant strains on the liabilities side of the balance sheet. For the first time, repo markets and others that have rightly relied on Treasury securities as the unquestioned reserve asset must now go to Plan B – whatever that is.

In addition to the capital and liquidity rules, another major regulatory initiative – the demand for “living wills” – is also based on an untrue premise. This one builds on the expectation that sovereign obligations are risk-free by demanding that bankers contemplate every scenario that could stress them out and, then, stockpile these risk-free assets just in case. This is like the government demanding that we all keep water in the basement against a 500-year flood and then quietly replacing the water with rotgut whiskey. We all will have tried our best to safeguard ourselves, but still be put at huge risk for actions wholly outside our control.

The solution isn’t to go back to the halcyon days of light-touch regulation. That was fun for bankers, but not so much for taxpayers and the macroeconomy. But, is it fair to expect bankers to protect themselves from any possible risk scenario and, then, to mandate that they do so through assets that aren’t in fact risk-free? This is of course an inherently contradictory policy that does nothing other than to permit sovereign debt issuers – read the governments writing the Basel rules – to pretend that they’re all still in the pink.

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