According to current banking regulations, sovereign credits are considered “risk-free.” This means that banks can take on as much sovereign credit risk as they like without setting aside any capital. Under such a structure, selling short CDS protection is akin to free money for the banks.
Likely, the real worry is that the first default will expose the fiction that sovereign debt is risk-free. If the authorities permit one default, their credibility to prevent additional defaults will be lost. No one knows how much aggregate exposure to sovereign debt and CDS is hidden in the banking system, and no one is itching to find out. The European regulators are trying to calm the market by conducting “stress tests” on the banks. This might be comforting if the stress tests included testing the possibility of a sovereign default. They do not. What is the point of a stress that fails to test the most obvious and visible risk facing the banks?
– David Einhorn, Greenlight Capial July 7, 2011