Featured Product

    ESRB Analyzes Impact of Diversification in Sovereign Bond Portfolios

    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

    Featured Experts
    Related Articles
    News

    FSB Sets Out Effective Practices for Cyber Incident Recovery

    FSB finalized the toolkit of effective practices to assist financial institutions in their cyber incident response and recovery activities.

    October 19, 2020 WebPage Regulatory News
    News

    HKMA Urges Early Action for Adherence to IBOR Fallbacks Protocol

    HKMA urged authorized institutions to take early action to adhere to the IBOR Fallbacks Protocol, which ISDA is expected to publish soon.

    October 16, 2020 WebPage Regulatory News
    News

    FSB Sets Out Roadmap for Transition to Alternative Reference Rates

    FSB published a global transition roadmap for London Inter-bank Offered Rate (LIBOR).

    October 16, 2020 WebPage Regulatory News
    News

    HM Treasury Publishes Response to Proposal on BRRD2 Transposition

    HM Treasury published a document that summarizes the responses received from a consultation on the approach of UK to transposition of the revised Bank Resolution and Recovery Directive (BRRD2).

    October 15, 2020 WebPage Regulatory News
    News

    HM Treasury Publishes Response to Proposal on CRD5 Transposition

    HM Treasury published the government response to the feedback received on the consultation for updating the prudential regime of UK before the end of the Brexit transition period.

    October 15, 2020 WebPage Regulatory News
    News

    BoE Publishes Reporting Schedule for Statistical Returns

    In a recent statistical notice, BoE announced publication of the reporting schedule for statistical returns for 2021.

    October 15, 2020 WebPage Regulatory News
    News

    EC Welcomes Declaration by Member States on EU Cloud Federation

    EC welcomed the joint declaration by 25 EU member states on building the next generation of cloud in Europe.

    October 15, 2020 WebPage Regulatory News
    News

    PRA Updates Supervisory Statement on Counterparty Credit Risk

    PRA published the final policy statement PS22/20, which contains the updated supervisory statement SS12/13 on counterparty credit risk.

    October 14, 2020 WebPage Regulatory News
    News

    FSB Publishes Update on Work to Address Market Fragmentation

    FSB published an update on its work to address market fragmentation. FSB is working in this area in collaboration with the other standard-setting bodies.

    October 14, 2020 WebPage Regulatory News
    News

    EBA Proposes to Revise Guidelines on Incident Reporting Under PSD2

    EBA proposed revisions to the guidelines on major incident reporting under the second Payment Service Directive (PSD2).

    October 14, 2020 WebPage Regulatory News
    RESULTS 1 - 10 OF 5967