Can European Banks Keep Buying Government Bonds?

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A review of balance sheets shows that European banks are carrying more government debt than in years past, the Wall Street Journal reports. Sovereign debt comprised 5.6 percent of the assets of banks in the eurozone at the end of this August, up from 4.2 percent at the end of 2011. This means that, as government have issued additional bonds, some of the larger holders of the debt have become European banks.

There are a whole host of complex factors that can explain the increase, but two of the primary reasons are quite simple. First, new regulations have encouraged banks to hold government debt because it is treated as a risk-free asset.

Reforms to the banking system have created very specific amounts of cash that banks have to carry in order to offset assets with different risk levels, as well as ratios of riskiness that banks must abide by between their different levels of assets. Holding government debt makes it much easier for banks to abide by the rules, allowing them to carry less cash on hand and maintain more of their other, nominally riskier activities.

Additionally, banks were flooded with the opportunity to invest by the creation of so-called LTROs — or long-term funding operations — which were essentially just lending programs by the European Central Bank to give banks money to infuse into the economy and increase the liquidity of the region.

However, many banks simply took the money — which was handed out at extraordinarily low interest rates — and bought government bonds, essentially taking advantage of an arbitrage opportunity to make a free, albeit small, rate of return.

However, this scenario has created an entirely new host of unforeseen problems. One issue is that banks are beginning to repay the money into the LTROs and, so far, the ECB is yet to announce the creation of a new operation. This means that, as money begins to dry out, governments may find it harder to find buyers for their bonds, which would in turn drive yields higher. This is exactly the situation that the central bank, and governments across the region, are trying to avoid, leading them to try and talk down interest rates by setting official rates exorbitantly low.

Meanwhile, the situation creates a huge problem for business owners seeking credit. Not only do they have to deal with banks, but they also have to compete with the government for the resources of the lending institutions that they are trying to obtain funding from. Some economists have expressed fears that the LTROs have failed to actually bring money into the economies of struggling European countries, instead being used to fuel governments through bond purchases.

The real issue that analysts have pointed out is that the scheme cannot continue indefinitely. With banks in Italy and Spain nearing the 10 percent mark in terms of assets that are actually just government debt, markets are beginning to wake up when it comes to analyzing the situation, and no label of “risk-free” can save bonds from the judgment of the markets when the time comes.

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