Tackling sovereign risk in European banks

The tight linkage between sovereign and bank balance sheets magnified the depth of the European sovereign debt crisis. As a response to this, reform efforts are therefore focused on severing this vicious tie. Some progress has been made. The Banking Union framework addresses the transfer of banking sector risk to the sovereign. Policy makers are now discussing how to address the treatment of sovereign debt on bank balance sheets. Currently, it is treated as risk free. Zero risk weights are applied, meaning banks do not need to set aside capital to protect themselves from potential losses in these securities. Nor do banks have any limits on their exposure to a particular sovereign. This discussion paper analyses the two widely discussed basic options to address this regulatory gap: applying non-zero risk weights to sovereign exposures, and putting limits on exposures to sovereigns, akin to those in place for other exposures. Although this paper analyses each option in isolation, the two complement one another as they target different facets of risk. Positive risk weights address counterparty credit risk, whereas large exposure limits address concentration risk.