Featured Product

    ECB Paper on Regulating the Doom Loop Between Banks and Sovereigns

    September 04, 2019

    ECB published a working paper on regulating the doom loop between banks and sovereigns. Euro area governments have committed to break the doom loop between banks and sovereigns. However, policymakers disagree on how to treat sovereign exposures in bank regulation. In this paper, the authors model endogenous sovereign portfolio reallocation by banks in response to regulatory reform. Simulations highlight a tension between concentration and credit risk in portfolio reallocation. Resolving this tension requires regulatory reform to be complemented by an expansion in the portfolio opportunity set to include an area-wide low-risk asset. By reinvesting into such an asset, banks would reduce both their concentration and credit risk exposure.

    The authors find that regulatory reforms targeting portfolio concentration indeed reduce banks’ home bias, but are consistent with increased sovereign credit risk exposure. Conversely, reforms aimed at reducing credit risk exposure can exacerbate concentration. None of the envisaged reforms unambiguously reduce both concentration and credit risk. Consequently, reforms could strengthen the doom loop through cross-border contagion. These findings reflect the incompleteness of euro area sovereign debt markets. A portfolio with both low concentration and low credit risk can only be assembled if the investible universe is expanded to include a security that entails both properties. The tension between concentration and credit risk is a general insight that reflects the sovereign portfolio opportunity set.

    Resolving this tension requires an expansion in the opportunity set to include a security that embeds both low concentration and low credit risk. Such an asset—defined as area-wide and low-risk—can be created by pooling and tranching portfolios of sovereign bonds. Simulations show that well-designed regulatory reform can complement the introduction of this asset by incentivizing banks to reinvest into it. In summary, the findings support two complementary policy actions. Together, these two policies are necessary to break the doom loop between banks and sovereigns:

    • First, facilitate the creation of an area-wide low-risk asset. This requires policymakers to remove the regulatory frictions that impede its market-led development.
    • Second, reform regulation to induce portfolio reallocation into an area-wide low-risk asset. Reforms mooted by BCBS (2017) and German Council of Economic Experts (2015) do not meet this condition and could even backfire by strengthening the doom loop. Instead, reforms that include positive capital charges or restrictive large exposure limits for all single-name sovereign bonds would complement an area-wide low-risk asset by incentivizing banks to reinvest into it. 

     

    Related Link: Working Paper (PDF)

     

    Keywords: Europe, EU, Banking, Sovereign Risk, Credit Risk, Concentration Risk, Sovereign Exposures, Portfolio Reallocation, Sovereign Bonds, Research, ECB

    Related Articles
    News

    APRA Consults to Standardize Submission Date for Quarterly Reporting

    APRA proposed to standardize quarterly reporting due dates for authorized deposit-taking institutions. The proposed standardized due date is 35 calendar days after the last day of the reference quarter, which will create a 14-calendar-day extension for credit unions and building societies.

    November 08, 2019 WebPage Regulatory News
    News

    EBA Publishes Methodology and Draft Templates for Stress Tests in 2020

    EBA published a package for the 2020 EU-wide stress test exercise for banks.

    November 07, 2019 WebPage Regulatory News
    News

    FSB Publishes Summary of Plenary Meeting in Paris

    At the meeting, the Plenary reviewed vulnerabilities in the global financial system, fintech developments (including developments in the crypto-asset markets), ongoing work of FSB, and the work program for 2020.

    November 07, 2019 WebPage Regulatory News
    News

    EC Publishes Results of Fitness Check of Reporting Requirements in EU

    EC published results of the fitness check of supervisory reporting requirements in financial services legislation in EU.

    November 07, 2019 WebPage Regulatory News
    News

    BCBS Assesses NSFR and LE Rules in Argentina and China as Compliant

    BCBS published reports that assess the implementation of net stable funding ratio (NSFR) and large exposures, or LE, framework in Argentina and China.

    November 07, 2019 WebPage Regulatory News
    News

    HKMA Highlights Technology Initiatives at the Hong Kong FinTech Week

    HKMA co-organized, with InvestHK, the Hong Kong FinTech Week 2019, which was a five-day flagship fintech event that attracted thousands of attendees worldwide.

    November 06, 2019 WebPage Regulatory News
    News

    ECB Report on Fallback Provisions in Contracts Referencing EURIBOR

    ECB published a report, by private sector working group on euro risk-free rates, presenting recommendations for fallback provisions in contracts for cash products and derivative transactions referencing EURIBOR.

    November 06, 2019 WebPage Regulatory News
    News

    EC Regulation on Homogeneity of Underlying Exposures in Securitization

    EC published the Delegated Regulation 2019/1851 regarding the regulatory technical standards on the homogeneity of the underlying exposures in securitization.

    November 06, 2019 WebPage Regulatory News
    News

    FSI Examines Regulatory Approaches on Climate Risk Assessment

    The Financial Stability Institute (FSI) of BIS published a paper that examines the regulatory approaches being used for climate risk assessment in the insurance sector, in particular through enterprise risk management (ERM) frameworks.

    November 06, 2019 WebPage Regulatory News
    News

    SRB Launches Q&A Process for Resolution Reporting

    SRB has setup a dedicated solution for raising questions on the resolution reporting.

    November 06, 2019 WebPage Regulatory News
    RESULTS 1 - 10 OF 4112