There is a venerable history of interdependence between sovereign debt and the financial system.  The national banking system in the U.S. arose as a solution to fiscal challenges the Union government faced in the Civil War.  A key requirement for chartering a national bank was that a third of its capital had to be devoted to government debt.[1]  A subsequent statute eviscerated state banks by charging a tax on notes they issued, giving national banks that devoted substantial resources to financing the Union debt a vital competitive advantage.[2]

For observers of financial institutions, there is nothing novel in the claim that governments pressure financial intermediaries to absorb, and facilitate markets in, government debt.  However, not all pressure is created equal.  The calls for the Federal Reserve to lower interest rates towards reducing debt service payments on U.S. sovereign debt represent a more pernicious form of pressure.  Interest rate policy is designed to serve monetary rather than fiscal goals.  Undermining the apparatus for calibrating monetary policy damages this valuable social instrument.

In a recent paper, I explore another setting where political fiscal concerns may undermine policymaking.  Financial stability regulation involves the government in assessing the relative desirability of various assets, including sovereign debt.  In making these assessments, lawmakers face a conflict of interest.  Ideally, lawmakers would balance financial stability considerations against efficiency considerations.  However, when governments specify the relative desirability of assets within the financial system, they have opportunities to enable fiscal policies at home and abroad.  It is this potential for encouraging the financial system to absorb government debt through financial stability regulation that my work uncovers and explores.

There are a number of contexts within financial regulation where the government specifies the relative desirability of various assets including U.S. and other sovereign debt.  These contexts include capital requirements, margin requirements, the regulation of money market funds and most recently, stablecoin regulation.[3]  My paper focuses on capital and margin regulation as case studies, while referencing other applications of the theoretical concerns it develops.

Capital

Capital regulation governs the allocation of assets within financial institutions.  U.S. commercial banks alone own $24.4 trillion in assets of which $4.5 trillion is U.S. government debt.  Considering the application of capital rules beyond commercial banks, the role of capital rules in asset allocation is even more significant.

As background, a firm’s assets can be financed by either debt or equity.  For a solvent firm, equity is defined as the difference between its assets and liabilities.  Capital regulations work through imposing carrots or sticks based on whether a firm meets certain ratios.  These ratios are calculated by dividing a measure of the firm’s equity by a measure of the firm’s assets.  As a result, capital ratios limit how much debt the firm can have relative to equity.  The goal of capital regulations is to provide firms with an equity cushion against losses.

There are several different capital regimes that apply in parallel to banking organizations.  An important example is a regime that requires a certain level of equity relative to “risk weighted assets.”  The risk weighting of assets is meant to account for their relative risk, so that more equity has to be carried against riskier assets.  Under the rules for risk-weighting assets, I show that the treatment of sovereign debt is substantially miscalibrated.  The risk weightings encourage investment in sovereign debt, enabling government spending.  This is particularly true with respect to riskier high income OECD member countries.

The Dodd-Frank Act categorically prohibits the use of credit ratings within regulations.  Although the Basel Committee that develops international capital standards recommends the use of credit ratings in risk-weighting sovereign debt, U.S. banking regulators were unable to do so because of the legislative prohibition.  Instead, U.S. capital rules base the risk-weighting of sovereign debt on risk assessments from the OECD.  It turns out that the OECD as a policy does not comment on the riskiness of high-income OECD member countries.  As a result, all sovereign debt of high-income OECD countries is treated as risk free under U.S. rules.  There are dozens of high-income OECD members with varying credit quality, including: Australia, Austria, Belgium, Canada, Chile, Czechia, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Latvia, Lithuania, Luxembourg, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, United Kingdom, and United States.

As aforementioned, there are several capital regimes working in parallel. With exceptions discussed in my paper, they all treat the majority of sovereign debt as risk free.[4] Ceteris paribus, this pushes banks towards holding more sovereign debt, and particularly, more sovereign debt from riskier high-income OECD countries. This is because debt from those countries pays higher interest while being treated as risk free under bank capital rules.  This approach expresses an undiscriminating internationalism that was ascendant under the Obama administration when the rules were adopted.  The costs of the approach are that it exposes banks to risk from less credit-worthy high-income OECD countries such as Hungary (currently rated BBB-) and that it crowds out other assets such as corporate debt.

Margin

Another example of how the conflict of interest may skew financial stability regulation is more complicated and comes from margin rules.  Margin rules require the collateralization of certain transactions.  The goal of collateral is to help assure performance.

One of the reforms under the Dodd Frank Act was the requirement to margin swaps.  This was done through a two-part mandate.  First, certain more liquid swaps have to be cleared.  Clearing involves interposing a central counterparty or CCP between the original parties to a transaction.  Cleared transactions are subject to margin requirements specified by the CCP in its capacity as a self-regulatory organization.  Second, those swaps that do not have to be cleared are subject to margin requirements specified under rules of federal regulators.  The swaps market is substantial, and when these reforms were being implemented, they were thought to require approximately $1.5 trillion in additional collateral.

Differences between SRO margin requirements imposed on cleared swaps and margin requirements imposed on uncleared swaps under the rules of federal regulators suggest miscalibration.  Taking a step back, the design of collateral rules requires regulators to address several questions, including what collateral to permit and how much to haircut the collateral to protect against volatility in its value.  These decisions, in turn, make certain assets more or less desirable as collateral.  My research looks at the rule sets and suggests that decisions were made that skew demand for sovereign debt.

Table A: Clearinghouse Collateral Rules[5]

Table B: Federal Regulators’ Collateral Rules

Tables A and B report respectively the permitted collateral and haircuts of the main U.S. CCPs and the permitted collateral and haircuts under federal margin rules.[6]  The tables reflect that CCPs differ as to collateral practices but are more conservative than federal regulators.  First, it appears that CCPs overly favor U.S. sovereign debt.  Second, CCPs overly favor sovereign debt relative to other assets such as corporate debt.  And third, federal regulators may be too lax or undiscriminating in the sovereign debt they permit or how they haircut it.  These observations pose puzzles with which my paper engages.  One reason for the relative laxity of federal rules may be that BCBS and IOSCO intervened in their development after the original proposal of margin rules, which would have only allowed cash and U.S. sovereign debt to serve as collateral.  However, there are other potential explanations, including that CCPs as SROs favor their regulator through supporting markets in U.S. debt.

Conclusion

With growing federal debt and eroding institutions, I perceive the risk of fiscal considerations infecting financial-stability policymaking only growing.  Indeed, there are questions as to why the assets permitted under the GENIUS Act to back stablecoins are limited to cash and U.S. government debt.  Notably, other sovereign debt and even high-grade corporate debt and gold could have been permitted, subject to appropriate haircuts – but were not.

One potential approach to these issues is the cultivation of awareness among debt-market participants and bureaucrats at federal agencies carrying out financial stability policy.

ENDNOTES

[1] https://www.occ.treas.gov/about/who-we-are/history/history-of-the-occ/founding-occ-national-bank-system/index-founding-occ-national-banking-system.html.

[2] Id.

[3] Kate Duguid and Claire Jones, Scott Bessent Bets on Stablecoins to Bolster Demand for Treasuries, Fin Tim (Aug 20, 2025) (“Treasury secretary Scott Bessent is betting the crypto industry will become a crucial buyer of Treasuries in coming years as Washington seeks to shore up demand for a deluge of new US government debt.”).

[4] Important exceptions that help offset this miscalibration apply (a) if the sovereign debt is in the trading book rather than being held to maturity, (b) under the leverage ratios, and (c) potentially, under stress tests.

[5] Notably, European clearinghouses (e.g., LCH, Eurex) have substantially more permissive collateral rules.

[6] These three CCPs collectively hold approximately 80 percent of the initial margin for cleared derivatives transactions in the U.S.  Ketan B. Patel, How Concentrated is the Clearing Ecosystem and How Has it Changed Since 2007?, 497 Chi. Fed. Letter 1, 3 (July 2024).

This post comes to us from Ilya Beylin at Seton Hall Law School.  It is based on his recent paper, “Fiscal and Foreign Relations Dimensions of Financial Stability Regulation,” forthcoming in the Villanova Law Review and available here.