Feasibility Check: Transition to a New Regime for Bank Sovereign Exposure?

1.    The accumulation of sovereign debt in the hands of poorly-capitalized banks contributed substantially to the worsening of the sovereign debt crisis in 2011 and 2012, as well as to the slow and asymmetric economic recovery of European countries. A diabolic feedback loop between banks and sovereigns developed in economically unstable countries. The flight-to-quality from distressed countries to safe countries reinforced the doom loop in the crisis countries. Moreover, due to banks’ cross-country holdings of sovereign bonds, and as banks did not fund these exposures with capital, risks could spill over from risky to safe countries, creating feedback loops even in safer countries.

2.    A new regime to regulate banks’ sovereign bond holdings thus should meet four criteria:

(1) attenuate the home bias to the domestic sovereign, (2) break the doom loop, (3) avoid a flight-to-quality, and (4) mitigate risk spillovers.  

3.    The resilience of the European banking sector has improved in the last several years due to new capital and liquidity requirements and, more broadly, to the introduction of the Basel III regulatory framework. Regulatory capital ratios have substantially improved as a result. However, the banking sector is still weak, as risk indicators (e.g., asset quality and profitability) suggest. Imposing additional capital requirements to further strengthen the European banking sector requires the planning of a transition period.

4.    Banks have substantial exposures to eurozone sovereign bonds. But banks also have large exposures to public entities within a country (e.g., municipalities). A new regulatory regime should carefully define what type of exposures count towards the same concentration of risk and which exposures can be separated. This has important consequences with respect to possible capital shortfalls under concentration limits or risk weights, particularly for state-owned banks.

5.    Removing sovereign debt privileges requires either the introduction of risk weights (as a function of the underlying asset risk), the introduction of concentration limits (as a function of a bank’s capital) or a combination of both. There are considerable disadvantages associated with each approach. For example, risk weights are highly procyclical, while diversification of sovereign risk in banks’ portfolios due to concentration limits increases spillover risks. We present seven policy proposals and analyse the impact of five of them on banks’ regulatory capital, based on simulations performed on a sample of 51 EU banks.

6.    The reform proposals for a new regulatory regime discussed in this paper include: (1) the introduction of a 10% risk weight floor, (2) the removal of the carve out option, (3) the application of a 25% concentration limit on sovereign exposures, (4) the implementation of risk adjusted large exposure limits as suggested by the German Council of Economic Experts (GCEE), (5) Risk weights scaled by large exposures, (6) the introduction of Sovereign Bond Backed Securities (SBBS) as discussed by Brunnermeier et al. (2016), and (7) the implementation of the Eurozone basket as suggested by Matthes and Rocholl (2017).

7.    Of these proposals, only the proposal by Brunnermeier et al (2016) fulfills the four criteria described above. This is because the proposal explicitly considers the creation of a safe asset through the introduction of SBBS, which is essential in fulfilling all four criteria. However, there are several questions about the viability of implementing SBBS.

A fiscal union might be the only solution that mitigates the problems associated with the bank-sovereign nexus and permanently restores the value of sovereign bonds as a risk-free asset (Acharya and Steffen, 2017).

You can download the paper provided in the context of Economic Dialogues with the President of the Eurogroup in ECON here.

References:

Acharya, V.V., Steffen, S., 2017. The Importance of a Banking Union and Fiscal Union for a Capital Markets Union. Prepared for European Commission, Directorate General for Economic and Financial Affairs.

Brunnermeier, M. K., Garicano, L., Lane, P., Pagano, M., Reis, R., Santos, T., Thesmar, D., Van Nieuwerburgh, S., Vayanos, D., 2016. The Sovereign-Bank Diabolic Loop and ESBies. American Economic Review Papers and Proceedings, 106 (5), 508–512.

Matthes, D., Rocholl, J., 2017. Breaking the doom loop: The euro zone basket. ESMT White Paper No, WP-17-01.