Banking regulation fuels sovereign debt gambling
A new working paper from the Federal Reserve Bank of Philadelphia argues that banking regulation, by designating domestic government debt as safe despite its risk, induces banks to gamble with depositors' funds. This practice links sovereign defaults directly to banking crises, while lowering government borrowing costs.
The perverse incentive of 'safe' debt
Banking regulation routinely designates domestic government debt as safe, even when it carries significant risk.
This regulatory oversight, as shown in a parsimonious model, induces domestic banks to "gamble" with depositors' funds by acquiring risky government bonds and correlated assets.
Consequently, sovereign defaults frequently trigger severe banking crises.
The paper highlights a critical moral hazard: by permitting banks to engage in such gambling, regulators inadvertently lower the government's ex-ante borrowing costs.
This creates a perverse incentive for governments to disregard the inherent riskiness of sovereign bonds, effectively gambling for redemption to avoid or postpone a looming debt crisis.
Empirical evidence from sovereign debt crises in Russia (1998), Argentina (2001), and the Eurozone (2010s) supports these theoretical implications, demonstrating the direct link between banks' excessive exposure to sovereign risk and subsequent financial instability.
Limited liability, unlimited risk
Banks' limited liability creates incentives for excessive risk-taking.
Prudential regulation, which typically requires sufficient capital, traditionally exempts government debt as a "safe" asset.
This exemption becomes problematic when sovereign debt is actually risky, enabling banks to gamble by acquiring such debt while still meeting regulatory compliance.
The model explores equilibrium outcomes across various capital requirements and risk weights for government bonds.
A central theoretical result is that government borrowing costs are lower if banking regulation overlooks the risk of sovereign default, as this allows banks to gamble with depositors' funds.
A regulatory blind spot with systemic costs
This paper starkly exposes a fundamental flaw in banking regulation that actively encourages systemic risk.
By allowing governments to offload their borrowing costs onto the financial system, the framework creates a dangerous moral hazard.
The long-term societal costs of such regulatory arbitrage far outweigh any short-term fiscal benefits.