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    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

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