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

    HKMA Sets Out Regulatory Treatment for Personal Loan Guarantee Scheme

    HKMA has published a circular that sets out the regulatory and reporting treatment for loans that participating authorized institutions may grant to eligible borrowers under the 100% Personal Loan Guarantee Scheme.

    April 20, 2021 WebPage Regulatory News
    News

    ECB Completes Targeted Review of Internal Models of Banks

    ECB published the results of the assessment of internal models that banks use to calculate risk-weighted assets for credit, market, and counterparty credit risks.

    April 19, 2021 WebPage Regulatory News
    News

    PRA on Regulatory Treatment of Loans Under Mortgage Guarantee Scheme

    PRA published a statement on the regulatory treatment of retail residential mortgage loans under the Mortgage Guarantee Scheme, or MGS.

    April 19, 2021 WebPage Regulatory News
    News

    FCA Consults on Rules and Reporting Forms for Investment Firms Regime

    FCA is consulting, via CP21/7, on the second phase of proposed rules to introduce the UK Investment Firm Prudential Regime (IFPR).

    April 19, 2021 WebPage Regulatory News
    News

    HMT and BoE Decide to Explore Central Bank Digital Currency in UK

    HM Treasury and BoE announced the joint creation of a Central Bank Digital Currency (CBDC) Taskforce to coordinate the exploration of a potential central bank digital currency in UK.

    April 19, 2021 WebPage Regulatory News
    News

    EIOPA Sets Out Expectations on Use of Climate Risk Scenarios in ORSA

    EIOPA published an opinion to set out its expectations on the supervision of the integration of climate change risk scenarios by insurers in their Own Risk and Solvency Assessment (ORSA).

    April 19, 2021 WebPage Regulatory News
    News

    EC Sets Out Standards for MREL Reporting by Competent Authorities

    EC published the Implementing Regulation 2021/622 that lays down implementing technical standards for reporting of the minimum requirement for own funds and eligible liabilities (MREL).

    April 16, 2021 WebPage Regulatory News
    News

    BCBS to Advance Work on Suptech, Climate Risk, and Basel Monitoring

    BCBS has set out the strategic work priorities, as part of its the work program for 2021-22.

    April 16, 2021 WebPage Regulatory News
    News

    Bundesbank Updates AnaCredit Reporting Requirements

    Bundesbank published two circulars on AnaCredit reporting requirements. Circular 27/2021 covers changes to the reporting of branches, additional attributes to be reported for investment funds from August 01, 2021, and updates to the list of international organizations.

    April 16, 2021 WebPage Regulatory News
    News

    PRA Finalizes Supervisory Approach for Non-Systemic Banks in UK

    PRA published the policy statement PS8/21, which contains the final supervisory statement SS3/21 on the PRA approach to supervision of the new and growing non-systemic banks in UK.

    April 15, 2021 WebPage Regulatory News
    RESULTS 1 - 10 OF 6874