Changing the treatment of sovereign exposures in banking regulation: A market impact assessment

Abstract

While many efforts have been made recently by the EU to prevent spill-overs of banking crises to the fiscal domain, potential contagion from sovereigns to banks is yet to be addressed by public policy. This study provides a quantitative impact assessment of a potential tightening in the banking regulatory framework of sovereign exposures within the EU, either in the form of large exposure limits or non-zero risk weights. Such a shift in regulation would require a large portfolio rebalancing for the banking sector in the euro area, and would lead to large excess supply on government bond markets, as well as leading to potentially sizable impact on long-term yields. The impact on banks and bond markets in the non-euro area EU economies are also found to be sizable, while in these countries the adjustment would not be supported by common risk-sharing mechanisms.