Major default

Latest blast from Basel misses obvious target

The Basel Committee wants to reduce banks' exposure to any one institution, in order to reduce overall risk. Yet, it has ignored one critical group of counterparties: governments. The committee has given the banking industry three months to respond to its proposals and says it will look at sovereign debt at a later stage. But time is of the essence. Cyprus has shown that the spectre of sovereign default still haunts Europe's banks.

The logic behind the latest measures to shore up lenders is sound. The Switzerland-based rule setters plan to halve the largest possible exposure a bank can have to a single financial or corporate firm. By reducing this exposure to a maximum five per cent of their core equity, from the current 10 per cent, banks would be less likely to totter if their largest counterparties defaulted.

Some aspects of the proposals are well-thought through: they consider the possibility that several smaller counterparties could carry a large, combined default risk; they also include most forms of financial instruments and central counterparty clearing. Recommendations on limiting exposures to credit protection providers would probably have prevented the knock-on effects triggered by the collapse of US insurer AIG.

Basel concedes that nailing default risk would serve only as a "backstop" to risk-weighted capital requirements. Still, it's encouraging that the committee wants to impose a hard cap on lenders and doesn't allow national discretion. It's also right that the standard requirements would not be open to model-fiddling by banks.

Yet, it's harder to see why the most globally systemic institutions - the G-SIBs in Basel's lingo - would be allowed higher exposures to their biggest peers. They may have higher capital requirements than less systemically critical banks. But under the proposals, G-SIBs would be allowed an exposure of between 10 and 15 per cent to another behemoth. That would do little to reduce the concentration of risk that Basel says it is fighting.

Worst of all, sovereign default risk has been excluded. As long as some countries allow government debt to be counted as risk-free, the doom loop between governments and banks will linger. Basel needs to get its ducks in a row - and that means tackling sovereign risk as soon as possible.