Featured Product

    ESRB Analyzes Impact of Diversification in Sovereign Bond Portfolios

    March 14, 2019

    ESRB published a working paper on the effects of possible EU diversification requirements on the risk of sovereign bond portfolios of banks. The paper analyzes the effects of possible responses of banks to a new diversification requirement for exposures in sovereign bond portfolios.

    In the current Basel framework, a special treatment is reserved for exposures of European banks to domestic government bonds. Banks are not required to hold any capital buffer against their investments in sovereign bonds denominated in euro, which are considered de facto riskless. Furthermore, sovereign exposures are not subject to any concentration limits and can represent a large part of the capital of banks. Consequently, there are strong regulatory incentives for banks to hold disproportionate amounts of domestic sovereign debt for capital and liquidity reasons. Recently, the EU policymakers proposed the introduction of capital rules and diversification requirements for euro area government bond holdings, primarily to weaken the "doom loop" between sovereigns and banks. To inform the policy discussion, this paper analyzes the effects of possible responses of banks to the new diversification requirement. 

    The analysis covers a sample of 106 European banks included in the EBA stress testing dataset during June 2013 to December 2015. These banks cover approximately 70% of banking assets in their respective countries and across EU. Sovereign exposures represent a large part of their total assets and are much larger than the capital of banks. First, the paper uses an independent component analysis to capture the dependence structure of sovereign risks of European countries and identify the common factors driving European sovereign CDS spreads. Next, the report analyzes risk and diversification in the sovereign bond portfolios of the largest European banks and discusses the role of “home bias”—that is, the tendency of banks to concentrate their sovereign bond holdings in their domicile country. Finally, the paper evaluates the effect of diversification requirements on the tail risk of sovereign bond portfolios and quantifies system-wide losses in the presence of fire-sales.

    The analysis shows that reducing home bias by forcing banks to hold less concentrated sovereign portfolios may not necessarily lead to a decrease in portfolio risk for all countries or to a more stable banking system, especially during crises, when the dependence structure of sovereign risks should be taken into account. While the analysis of fire-sales indicates that diversification reduces fire-sale losses, this result must be tempered by possible network effects that may work in the opposite direction. If the regulatory authority introduces a large exposure regime, it may force connections and dependence between banks through joint cross-holdings, which represent an important channel of contagion in the presence of financial distress. Contagion can indeed occur because of fire-sales that result in devaluation of assets and contagion risk may thus increase with diversification. However, the paper concludes that estimating the most likely bank response to differing diversification requirements is an important task for future study.

     

    Related Link: Working Paper (PDF)

     

    Keywords: Europe, EU, Banking, Securities, Sovereign Exposures, Sovereign Risk, Concentration Risk, Sovereign Bonds, ESRB

    Featured Experts
    Related Articles
    News

    APRA Issues Operational Risk Rules, Consults on Reporting Requirements

    APRA published an updated prudential standard APS 115 that sets out operational risk requirements for authorized deposit-taking institutions in Australia.

    December 11, 2019 WebPage Regulatory News
    News

    APRA Decides to Keep Countercyclical Capital Buffer for Banks at 0%

    APRA announced its decision to keep the countercyclical capital buffer (CCyB) for authorized deposit-taking institutions on hold at zero percent.

    December 11, 2019 WebPage Regulatory News
    News

    EBA Issues Revised List of Validation Rules for Reporting by Banks

    EBA published a revised list of validation rules in its implementing technical standards on supervisory reporting.

    December 10, 2019 WebPage Regulatory News
    News

    SRB Holds Annual Conference, Reflects on Turning Policy into Action

    SRB published a report on its fourth annual conference that was held on October 10, 2019 in Brussels.

    December 10, 2019 WebPage Regulatory News
    News

    FED Extends Consultation Period for Capital Requirements for Insurers

    FED is extending comment period for the proposed rule establishing risk-based capital requirements for depository institution holding companies that are significantly engaged in insurance activities.

    December 10, 2019 WebPage Regulatory News
    News

    OSFI Sets Domestic Stability Buffer Level at 2.25%

    OSFI has set the Domestic Stability Buffer, or DSB, at 2.25% of total risk-weighted assets, with effect from April 30, 2020.

    December 10, 2019 WebPage Regulatory News
    News

    FSB Examines Financial Stability Aspects of Bigtech and Cloud Services

    FSB published two reports that consider the financial stability implications from the offering of financial services by bigtech firms and the adoption of cloud computing and data services across a range of functions at financial institutions.

    December 09, 2019 WebPage Regulatory News
    News

    HKMA Proposes Changes to Module on Supervision of Concentration Risk

    HKMA issued a circular proposing revisions to the Supervisory Policy Manual module CR-L-1 on consolidated supervision of concentration risks under the Banking (Exposure Limits) Rules (BELR) Rule 6.

    December 09, 2019 WebPage Regulatory News
    News

    BoE Updates XBRL Filing Manual for Reporting Under Solvency II

    BoE has updated the XBRL filing manual (to Version 5.0) to help firms and software vendors create XBRL instance documents for Solvency II Pillar 3 and BoE Insurance reporting.

    December 09, 2019 WebPage Regulatory News
    News

    APRA Specifies Capital Treatment of Equity Investments in ABGF

    APRA published a letter to the authorized deposit-taking institutions outlining the regulatory capital treatment of their equity investments in the Australian Business Growth Fund (ABGF).

    December 09, 2019 WebPage Regulatory News
    RESULTS 1 - 10 OF 4301