Bundesbank chief in new warning on sovereign debt

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The president of Germany's central bank has warned of rising levels of government debt on bank balance sheets and has called for a regulatory overhaul.

Writing in the Financial Times, Jens Weidmann, head of the Bundesbank, said the "deadly embrace" in which banks with heavy exposure to euro zone sovereign debt need rescuing, needs to be broken.

According to him, rather than cutting back on sovereign debt, euro zone banks had actually increased their holdings of sovereign bonds since the crisis.

(Read More: Failure to reform threatens markets: Bundesbank's Nagel )

Current regulations made it "highly attractive" for banks to invest in government bonds, and especially those of their home countries, Weidmann argued. As a result, the debt now makes up 5.3 percent of total bank assets in the euro zone - an increase of a third from five years ago.

"The time is ripe to address the regulatory treatment of sovereign exposures. Without it, I see no reliable way of breaking the sovereign-banking nexus," he wrote.

His comments come as the European Central Bank (ECB) considers whether to offer further LTROs (Long Term Refinancing Operations), allowing banks to access cheap credit in return for collateral in the form of sovereign bonds.

(Read More: ECB Cannot Solve Euro Zone Crisis, Says Bundesbank Chief )

The ECB has already launched two LTROs - worth around 1 trillion euros ($1.36 trillion) - in an effort to tackle the region's debt crisis.

Weidmann said that recent studies had shown the banks most likely to invest in sovereign bonds were larger institutions, those with less capital and banks dependent on wholesale funding.

"Hence, the more vulnerable banks are, the more they expose themselves to sovereign debt," he wrote.

(Read more: ECB's Draghi says euro zone recovery 'fragile' )

Additionally, banks have an incentive to bet on sovereign bonds - because if the country defaults, the bank will likely default too. Large exposure to government debt could also hurt the wider economy, Weidmann added, as increasing sovereign risk is transmitted into reduced bank lending.

"Thus, the current regulatory treatment is incompatible with the principle of individual responsibility; the market interest rate no longer reflects the riskiness of the investment," he wrote, calling for a diversification in banks' holdings.

"The contingent liabilities of the government would shrink which - all other things being equal - would reduce the risk of investing in sovereigns and, eventually lower the sovereign bond yields."

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