Banks’ Sovereign Exposures: In Search of New Rules

Abstract

In this article, we examine the reform of the prudential treatment of banks’ sovereign exposures with the purpose of introducing risk-sensitive capital charges and limiting home bias. We consider six different options and measure their impact on the common equity Tier 1 (CET1) ratio of 82 banks fom 10 euro-area countries, participating in the 2019 European Banking Authority EU-wide transparency exercise and subject to European Central Bank supervision. Our evidence shows that the proposal put forward by the Basel Committee on Banking Supervision in 2017 is the proposal which leads to the most evenly distributed impact across countries, in terms of CET1 ratio decline. That proposal targets the goals of risk sensitivity and diversification, with two independent instruments: rating-based risk weights and concentration add-ons. As a consequence, it is the only proposal which introduces an incentive for banks located in all countries, whether low rated or high rated, to reduce their home bias. Some proposals focus on one objective only: either risk sensitivity or diversification. Others introduce heavy penalization for banks located in low-rated countries, without addressing the home bias of banks located in high-rated countries. Several options are prone to pro-cyclicality, and we measure this effect by simulating the impact of a two-notch downgrading of high debt countries on the CET1 ratio of banks. Some relevant cross-country effects emerge from our analysis, due to the large cross-country exposures of a few intermediaries.