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

    PRA Revises Branch Return and Updates Guidance for Regulatory Reports

    PRA published the policy statement PS17/19, which contains the final policy related to changes in the format and content of the Branch Return Form and reporting guidance.

    September 12, 2019 WebPage Regulatory News
    News

    FINMA Outlines Treatment of Stablecoins in Supplement to Guide on ICO

    FINMA published a supplement to its initial coin offerings (ICOs) guidelines, outlining the treatment for stablecoins under the Swiss supervisory law.

    September 11, 2019 WebPage Regulatory News
    News

    Ursula von der Leyen Presents Structure of Next European Commission

    President-elect Ursula von der Leyen has presented her team and the new structure of the next European Commission.

    September 10, 2019 WebPage Regulatory News
    News

    FED Proposes to Revise and Extend Reporting Form on Systemic Risk

    FED proposed to extend for three years, with revision, the Banking Organization Systemic Risk Report (FR Y-15; OMB No. 7100-0352).

    September 10, 2019 WebPage Regulatory News
    News

    EBA Issues Revised List of Validation Rules for Reporting

    EBA published the revised list of validation rules (version 2.9) in its implementing technical standards on supervisory reporting.

    September 10, 2019 WebPage Regulatory News
    News

    Bundesbank Publishes Supplementary Validation Rules for Reporting

    Bundesbank published the updated document containing supplementary validation rules in the context of the implementation of the reporting system at national level.

    September 10, 2019 WebPage Regulatory News
    News

    APRA Licenses Xinja Bank as Authorized Deposit-Taking Institution

    APRA granted Xinja Bank Limited a license to operate as an authorized deposit-taking institution without restrictions, under the Banking Act 1959.

    September 09, 2019 WebPage Regulatory News
    News

    FDIC Proposes Revisions to Regulations on Interest Rate Restrictions

    FDIC proposed revisions to its regulations covering interest rate restrictions that apply to less than well-capitalized insured depository institutions.

    September 09, 2019 WebPage Regulatory News
    News

    EBA Intends to Clarify End-Treatment of Grandfathered Instruments

    EBA announced its intention to clarify the prudential treatment applicable to own funds instruments at the end of the grandfathering period, which expires on December 31, 2021.

    September 09, 2019 WebPage Regulatory News
    News

    IMF Releases Reports on 2019 Article IV Consultation with Saudi Arabia

    IMF published its staff report and selected issues report in context of the 2019 Article IV consultation with Saudi Arabia.

    September 09, 2019 WebPage Regulatory News
    RESULTS 1 - 10 OF 3799