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Has the EU Already Broken Up?

Wednesday, 24 Nov 2010 | 12:22 PM ET

What if the European Union broke up—and nobody bothered to tell you about it? Well, some are speculating that it has already happened.

Of course, the modality of this breakup isn't an ostentatious Inverse Maastricht Treaty. There have been no ribbon cuttings—nor televised photo ops of smiling finance ministers walking across a national border.

There hasn't even been the kind of somber debate, often heard on BBC News or C-SPAN, hashing out the various merits and disadvantages of such proposal.

It just happened—in the course of doing business.

As I observed in a piece about the possibility of a looming fiscal crisis in the United States: "The most powerful force in the universe isn't love: It's the bond markets."

So, how have the bond markets in Europe been driving a breakup inside the Union that few outside the world of sovereign finance have noticed?

In London, the Financial Times blog Alphaville has been exploring just such an idea.

Here's the background:

The second version of the Basel Accords, a set of recommendations set up to help govern the international system of banking, specifies how much capital banks must set aside as a hedge against price deterioration of other assets in their portfolio. The so-called Basel II Accords allows banks to classify government bonds that are rated AA- or higher as a "zero risk" with regard to capital requirements.

Classifying a bond with a "zero risk" weighting means that a bank doesn't have to set aside additional capital when holding a bond. As you might imagine, setting aside capital effectively decreases the rate of return on asset.

For example, imagine that you own a total $200,000 worth of bonds. Now imagine that half the bonds you own are issued by Country A, and half the bonds you own are issued by Country B. In this example, let's say you own equal amounts of both bonds: $100,000 worth of Country A's bonds, and $100,000 worth of Country B's bonds. Both bonds pay an identical 5 percent interest. If you had to set aside a 20 percent capital cushion for bond B but not for bond A, you'd only be earning 5 percent interest on $80,000 in principal—which would dramatically lower your yield on Bond B.

Well, what is happening now in the credit markets is essentially a splitting up of the Bond universe.

As I pointed to this morning, Standard & Poor's has just cut the credit rating on Irish sovereign debt by two steps, and given it a negative outlook for the future.

In the words of The Financial Times blog Alphaville, "Ireland now joins countries rated A+ (Italy) or A- (Portugal) which require a 20 per cent risk weighting for their government bonds. Sovereigns who’ve been junked (sorry about this, Greece) but remain above B-, go all the way to 100 per cent risk weighting."

And, as a consequence of the rating cuts and current regulations, banks within the European Union would likely be disinclined to hold debt of nations with lower credit ratings, because of an inherent disincentive in their risk–hedged rate of return.

With different capital requirements for different nations within the European Union, and banks gravitating towards holding domestic bonds, is it possible that the dream of a truly unified Europe has already fractured beneath the surface? And are the fault lines beginning to deepen and radiate outward?

With,new proposals coming from German Chancellor Angela Merkel , the future direction is difficult to discern.

Alphaville's writers believe that it is possible that Merkel's proposal may "effectively destroyed this system’s gradations"—and lead to further fragmentation within the financial structures of the European Union.

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