At the heart of Europe’s bailout of Greece is concern over the solvency of European banks, particularly those in France and Germany. The largest holders of Greek sovereign debt include BNP Paribas, with over a 5 billion euro exposure, and Societe Generale (didn’t we bail them out of their AIG exposure too?). Perhaps it is lucky timing that international bank regulators begin meeting Friday to negotiate a revised set of standards for bank capital, under the Basel Committee on Banking Supervision. 

The previous standards, known as Basel II, played a central role in encouraging European banks to load up on Greek debt. Under Basel II the amount of capital a bank has to set aside to cover the default risk of any given asset is supposed to be “risk-based.” So higher risk assets require more capital than lower risk assets. Sounds reasonable in concept. But once the government gets involved, reason is too often thrown aside in favor of politics. Basel II ended up taking the position that government debt, including that of Greece, would be treated, for capital purposes, as essentially risk-free. So for a bank deciding whether to lock its capital up in business lending or use that capital to hold government debt, the choice became obvious, with the result being massive leverage on the part of the banks and a huge exposure to Greece (among other supposed safe assets like Fannie Mae debt).

So while I believe Greece should not be bailed out, and the banks should take their losses despite the fact that the regulators helped create the problem, the regulators must fix the perverse incentives under Basel. Again, any capital regime that treats Greece (and Fannie Mae) as riskless is a regime designed to fail.