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The Financial Times published my letter to the editor last week responding to Gillian Tett’s article “Will sovereign debt be the new subprime?” I elaborated on the risks of increasing public debt in the U.S. and other developed countries, and warned that mere perception of an excessive supply of sovereign debt can reduce the real value of that debt. Here’s my letter:

Sir, Gillian Tett’s article “Will sovereign debt be the new subprime?” (November 23), regarding banks’ vulnerabilities as they increase holdings of government debt, is spot on. Although a number of analysts and even policymakers are warning about the potential sustainability problems of increasing public debt in the US and other developed countries, banks are piling on government liabilities – and bank regulators are not only approving but even encouraging those positions.

How could this be happening? In addition to Ms Tett’s explanations, I want to add the following: banks need to show adequate capitalisation at a time when the cost of raising capital is higher than in “normal times”. Thus banks have a strong incentive to hold assets that require the least possible regulatory capital.

Under current capital regulatory requirements in the US (Basel I), government bonds fit the bill. In the calculation of capital requirements, Basel I assigns zero risk weight to government paper, compared with as much as 100 per cent risk weight to corporate loans. Not surprisingly, banks would rather accumulate US Treasuries than lend to companies.

But US Treasuries and other government debt is not without risk! As Ms Tett explains, with rising fiscal deficits and the concurrent increase in the US debt, banks risk losing capital if the price of US bonds falls (that is, if interest rates increase). Have we seen this before? You bet. During the 1990s a large number of severe banking difficulties hit emerging markets (including Russia, Turkey and Latin American countries) when the price of the supposedly riskless asset, according to bank capital regulation, government debt – which was massively held by banks – suddenly plunged.

Of course, in contrast to emerging markets, the likelihood of the US and other industrial countries actually defaulting on their debt is close to nil, since they can always issue internationally accepted currency to pay their obligations. But, the mere perception of an excessive supply of sovereign debt can reduce the real value of that debt, and hence of banks’ capital. What is perplexing is that the same capital regulation that induced banks to sell mortgage loans excessively to structured investment vehicles, is now inducing banks to increase their holdings of assets that are becoming increasingly riskier. This under the vigilant eyes of supervisors!

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CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.