General Information & Client Service
  • Americas: +1.212.553.1653
  • Asia: +852.3551.3077
  • China: +86.10.6319.6580
  • EMEA: +44.20.7772.5454
  • Japan: +81.3.5408.4100
Media Relations
  • New York: +1.212.553.0376
  • London: +44.20.7772.5456
  • Hong Kong: +852.3758.1350
  • Tokyo: +813.5408.4110
  • Sydney: +61.2.9270.8141
  • Mexico City: +001.888.779.5833
  • Buenos Aires: +0800.666.3506
  • São Paulo: +0800.891.2518
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

Related Articles
News

EP Resolution on Proposal for Sovereign Bond Backed Securities

The European Parliament (EP) published adopted text on the proposal for a regulation of the European Parliament and of the Council on sovereign bond-backed securities (SBBS).

April 16, 2019 WebPage Regulatory News
News

FDIC Consults on Approach to Resolution Planning for IDIs

FDIC approved an Advance Notice of Proposed Rulemaking (ANPR) and is seeking comment on ways to tailor and improve its rule requiring certain insured depository institutions (IDIs) to submit resolution plans.

April 16, 2019 WebPage Regulatory News
News

HKMA Decides to Maintain Countercyclical Capital Buffer at 2.5%

HKMA announced that, in accordance with the Banking (Capital) Rules, the countercyclical capital buffer (CCyB) ratio for Hong Kong remains at 2.5%.

April 16, 2019 WebPage Regulatory News
News

EP Approves Agreement on Package of CRD 5, CRR 2, BRRD 2, and SRMR 2

The European Parliament (EP) approved the final agreement on a package of reforms proposed by EC to strengthen the resilience and resolvability of European banks.

April 16, 2019 WebPage Regulatory News
News

PRA Seeks Input and Issues Specifications for Insurance Stress Tests

PRA announced that it will conduct an insurance stress test for the largest regulated life and general insurers from July to September 2019.

April 15, 2019 WebPage Regulatory News
News

PRA Finalizes Policy on Approach to Managing Climate Change Risks

PRA published the policy statement PS11/19, which contains final supervisory statement (SS3/19) on enhancing banks’ and insurers’ approaches to managing the financial risks from climate change (Appendix).

April 15, 2019 WebPage Regulatory News
News

EC Launches Pilot Phase on Implementation of Ethical Guidelines for AI

EC launched a pilot phase to ensure that ethical guidelines for the development and use of artificial intelligence, or AI, can be implemented in practice.

April 15, 2019 WebPage Regulatory News
News

EBA Single Rulebook Q&A: First Update for April 2019

EBA published answers to nine questions under the Single Rulebook question and answer (Q&A) updates for this week.

April 12, 2019 WebPage Regulatory News
News

EIOPA Statement on Application of Proportionality in SCR Supervision

EIOPA published a supervisory statement on the application of proportionality principle in the supervision of the Solvency Capital Requirement (SCR) calculated in accordance with the standard formula.

April 11, 2019 WebPage Regulatory News
News

FED Updates Form and Supplemental Instructions for FR Y-9C Reporting

FED updated the form and supplemental instructions for FR Y-9C reporting. FR Y-9C is used to collect data from domestic bank holding companies, savings and loan holding companies, U.S intermediate holding companies, and securities holding companies with total consolidated assets of USD 3 billion or more.

April 11, 2019 WebPage Regulatory News
RESULTS 1 - 10 OF 2920