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
Previous ArticleBCBS Survey Examines Challenges Banks Face in Implementing Basel III
BoE published a statistical notice (Notice 2020/9) explaining the approach for treatment of payment holidays on the profit and loss return or Form PL.
BoE updated the known issues document for the statistical reporting Forms AS and FV.
FED announced individual capital requirements for 34 large banks and these requirements go into effect on October 01, 2020.
SRB published a set of documents to give operational guidance to banks on implementation of the bail-in tool.
BIS published an update on the G20 TechSprint Initiative, which was launched in April 2020 and aims to highlight the potential for technologies to resolve regulatory compliance (regtech) and supervisory (suptech) challenges.
OSFI published a letter that provides an update on the milestones for the implementation of the IFRS 17 standard on insurance contracts.
EBA updated the report on the implementation of selected COVID-19 policies.
The Financial Stability Institute (FSI) of BIS published a brief note that examines the supervisory challenges associated with certain temporary regulatory relief measures introduced by BCBS and prudential authorities in response to the COVID-19 pandemic.
BCBS is consulting on the principles for operational resilience and the revisions to the principles for sound management of operational risk for banks.
BoE updated the reporting template for Form ER as well as the Form ER definitions, which contain guidance on the methodology to be used in calculating annualized interest rates.