May 15, 2018

ESRB published a working paper that addresses the issue of bank exposures to sovereign risk. The paper provides input into policy discussions by simulating reallocations of euro area banks’ sovereign bond holdings under new regulatory regimes.

Euro area governments have committed to break the doom loop between bank risk and sovereign risk. However, policymakers have not reached consensus on whether and how to reform the regulatory treatment of banks’ sovereign exposures. To inform policy discussions, this paper simulates portfolio reallocations by euro area banks under scenarios for regulatory reform. Simulations highlight a tension in regulatory design between concentration and credit risk. An area-wide low-risk asset—created by pooling and tranching cross-border portfolios of government debt securities—would resolve this tension by expanding the portfolio opportunity set. Banks could, therefore, reinvest into an asset that has both low concentration and low credit risk.

 

Related Link: Working Paper (PDF)

Keywords: Europe, EU, Banking, Sovereign Risk, Systemic Risk, Concentration Risk, Research, ESRB

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