We can now apply this cost/benefit analysis to the government bond market. Here we have a striking difference with the banking sector. The sovereign debt crisis occurs at a snail’s pace compared to banking crises. When investors sell government bonds and push the interest rate upwards, they affect the cost of borrowing of governments with some delay because the maturity of the bonds is typically of the order of five to seven years. As a result, there is not the imminent threat of a rapid collapse as there is with a banking crisis.
The result is that when the central bank faces a sovereign debt crisis the lack of immediate danger has the effect that a conservative central bank, such as the ECB, will attach more weight on the long-term benefits of reducing moral hazard. The central bank will therefore wait far longer to take action.
Note that this does not mean that moral hazard risk is more important in sovereign bond markets than in the banking sector. Bankers are just as likely to take additional risk when they know that in times of crisis the central bank will provide liquidity, as governments are. In addition, there is no reason to believe that the risks bankers take on is less dangerous than the risk taken on by governments. The only difference is that the imminence of a collapse is higher during a banking crisis than during a sovereign debt crisis. As a result, a central bank is likely to reduce the weight on moral hazard risk.
A forecast of action
The previous analysis leads me to the following forecast.
- The ECB will only act when the cost of inaction is immediate and clear.
As a result, the ECB is likely to wait until the sovereign debt crisis has degenerated into a full-scale banking crisis.
- There can be little doubt that the sovereign debt crisis will lead to a banking crisis.
The reason is that the continuing decline in the price of sovereign bonds will hammer the banks’ balance sheets to such an extent that the losses become unbearable.
In addition, sovereign debt crises lead to funding problems for banks and a risk of being shut out from the interbank market. Thus there is a moment when the sovereign debt crisis inevitably triggers a banking crisis. This will be the moment when the timing asymmetry between costs and benefits is such that the ECB will see the merits of being a lender of last resort. Only then will the ECB come to action.
via www.VoxEU.org
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