One of the more amusing things about the dynamics that fed the Eurozone sovereign debt crisis was the extent to which banks found themselves caught in a kind of vicious, self-feeding loop involving debt issued by their sovereigns.
The problem was that as the crisis worsened, banks became the only willing buyers of their sovereigns’ bonds. If you’re a bank with large holdings of government debt, you don’t want to not buy more, because when there’s a dearth of natural buyers, you need to step in lest yields should spiral even higher, leading to more capital losses for you, and so on, and so forth.
But as that supposedly “riskless” debt got riskier and riskier in Europe, bank balance sheets deteriorated commensurately and in some cases, their access to cheap financing was curtailed (see the Greek ELA example). Here’s how the Fed explains it in a paper published in 2014:
Doubts about the fiscal soundness of the sovereign, unrelated to the banking system, can also affect banks’ performance. In the extreme case of a sovereign default, losses incurred by the banks due to their holdings of government issued securities could threaten their solvency. Similarly, as sovereign stress leads to an increase in debt yields, funding costs for banks will likely rise and impact bank profitability. In some cases, the effect of sovereign stress on funding costs may be larger for those banks that are deemed to be “too-big-to-fail” by the market. As the ability of the government to support these banks is questioned by investors, funding costs can increase relative to those of other banks
The most direct channel for the transmission of sovereign stress to the banking sector is through the banks’ holdings of sovereign debt. Banks maintain a portion of their assets in sovereign debt for different reasons. In several countries, sovereign securities are the most liquid asset available, and banks can use them to store their liquid reserves to satisfy deposit redemptions. Banks also hold sovereign debt for investment purposes. Traditionally, bank regulators have considered sovereign debt less risky than corporate debt, allowing banks to fund a lower proportion of their sovereign debt holdings with capital.
The collateral channel describes changes in banks’ funding conditions that are explained by the quality of collateral held by banks. An important portion of banks’ financing is done through secured transactions, such as repurchase agreements, or repos for short (CGFS, 2011). And one of the main securities used for these collateralized transactions is sovereign debt. In a repo transaction, the amount of funds a bank can borrow against a portfolio of securities will depend on the credit and liquidity risk of that collateral. The “buyer” of these securities may impose a haircut (the difference between the market value and the purchase price of the asset at the start of the repo) to this collateral to take into account such risks. In normal times, sovereign securities are considered to have very low risk, thus, the haircuts applied to these securities are relatively small. However, in periods of sovereign stress, banks that are reliant on sovereign collateral to conduct their secured financing transactions may face notable funding constraints. The deterioration in the value of sovereign collateral is more likely to affect banks domiciled in countries where the sovereign is in distress, but it could also impact banks with holdings of sovereign debt issued by a foreign government in distress, transmitting the funding shock across borders.
And this dynamic logically leads banks to pull back on lending, worsening the economic malaise that in many cases led to the crises in the first place. Here’s Goldman ca. 2012:
Because of the interconnectedness of bank and sovereign balance sheets, developments in sovereign bond markets…also affect wholesale refinancing costs.. [furthermore], the dislocation of government bond markets erodes bank capital: for holders of government debt, capital losses are incurred as yields rise [which] constrains credit expansion.
Anyway, to return to the original idea, traffic is a complex system. It self organizes at a macro level by drivers or pedestrians following a simple algorithm at the micro level. That rule is something like “avoid collisions by keeping a safe distance from whoever is in front” and from it springs a cohesive and spontaneous system-wide order. Intricate networks of paths are created allowing individuals to reach one location from any other location, and to do so simultaneously. The non-linearity of the system is apparent when one considers the consequences of a traffic interruption somewhere. The answer is it depends which path is blocked, when and what type of traffic is in the vicinity of the interruption. So it might have no effect on traffic flow, or it might have a paralyzing effect. Finally, there is no central command to such a traffic system. One will spring up where ever there are people and no higher intelligence is required to build one.Of course, today many such networks are centrally planned, particularly road networks, which is why the traffic light example is so interesting. They are planned by a central agency. And behaviour on them is regulated by that central agency too, in the form of systems of traffic signs, speed bumps, bollards and traffic lights. All are intended to make the roads safer for users of the roads. The problem is that they don’t.The pioneering demonstration of this was by a traffic engineer called Hans Monderman who I think should be a household name. In 2001, he redesigned the landscape of the small town of Drachten in the Dutch province of Friesland by removing all traffic controls. There are no traffic lights, no traffic signs, no traffic islands and no arrows pointing people in the direction they’re supposed to be moving in.It may be counterintuitive, but the finding in Drachten has been that since it dispensed with such road safety measures the traffic system has become far more efficient. Traffic flow has doubled while the number of fatal road accidents has fallen (by 100%, to zero). Moreover, similar results have been reported wherever such schemes have been tried across Europe – in Germany, Sweden, the UK. Broadly speaking, traffic speeds have declined, the incidence of traffic accidents have fallen and traffic flow has increased.How can this be? What I find very interesting about these experiments is that criticisms of them almost universally involve people complaining that they don’t feel safer in such a regime. Indeed, surveys among the residents of Drachten have shown an increased perception that the roads are more dangerous. And I think that’s the key. We’re not supposed to feel totally safe when we’re on the road because we’re not totally safe. So roads without traffic lights are safer precisely because people are alert to the risk of accident: they pay attention to what others are doing; drivers wait until they’ve made eye contact with other drivers before making a move; pedestrians remain alert to the traffic all around them, and the traffic remains alert to them in turn.So because people feel less safe they keep their guard up, which makes them engage in less risky behaviour, which makes the system more safe. The traffic lights and road signs are well intentioned, but by subtly encouraging us to lower our guard they subtly alter the fundamental algorithm dictating micro-level driving behaviour. This causes a perverse macro-level outcome.You might be thinking that traffic lights don’t have anything to do with the markets we all work in. But I think they do. Instead of traffic lights and road signs think rating agencies; think Basle risk weights for Core 1 and Core 2 bank capital; think Solvency 2; or think of the ultimate market regulators of our currencies – the central banks – and the Greenspan/Bernanke â€šputâ€› which was once imagined to exist. Haven’t these regulators provided the same illusion of safety to financial market participants as traffic safety tools do for drivers? And hasn’t this illusion of safety been even more lethal?It’s very difficult to see how government bonds are anything other than â€šrisk assetsâ€› (let’s face it, all assets are). Yet insurers are buying them because they’ve been told to â€štake less riskâ€› (whatever that means) by the regulators. So they are taking more risk, and they will one day suffer the consequences. Banks in the eurozone are bust because they own so much of their local sovereigns’ debt. But they were told it was OK to do that by the regulators. So they let their guard down.