13 May 2024

CEPR: How zero-risk weights on sovereign debt can lead to capital misallocation

Financial institutions, especially in Europe, hold a disproportionate amount of domestic sovereign bonds on their balance sheets. This home bias is facilitated by regulation that allows banks to assign a zero-risk weight to sovereign debt issued by any EU country. This column argues that the zero-risk weight policy leads to capital misallocation and a significant reduction in household welfare. The misallocation has become more severe due to the increased fiscal spending following the COVID-19 pandemic. Current forecasts of debt-to-GDP ratios portend additional fiscal stress over at least the next decade. Reassuringly, positive risk weights can reduce capital misallocations. 

Article 89 (1) (d) of the Capital Requirements Directive of the European Banking Authority permits European domestic banks to assign a zero-risk weight for bank exposures to sovereigns issued by member states’ governments. While financial markets demand sizable risk premia on sovereign bonds of EU member states, banks are still allowed to treat the bonds as risk-free and assign a zero-risk weight in their books. The privileged treatment of European sovereign debt and the sovereign-bank nexus have stimulated a lively policy debate (see Schmidt et al. 2012 and Schnabel et al. 2016). Relatedly, large exposures to debt may lead to spillovers of public default risk in one country to another country (Steffen 2014). One proposal to alleviate the ‘deadly embrace’ between banks and the government is the introduction of risk weights on sovereign debt (Grande and Angelini 2014). These debates are also tightly connected to a much broader discussion on completing the capital market union and banking union as evidenced in a recent speech by Joachim Nagel (2024), president of the Deutsche Bundesbank.

Does a zero-risk weight impact capital misallocations and cause undesirable outcomes for the economy? Can positive risk weights on sovereign debt improve macroeconomic outcomes and financial stability? These are important questions for policymakers and a nascent academic literature on the sovereign-bank nexus. We contribute to this debate by assessing the implications of a zero-risk weight policy on sovereign debt. We contrast the results to an economy with positive risk weights and for different degrees of fiscal stress.

In our study (Fueki et al. 2024), we use a non-linear dynamic stochastic general equilibrium model with a banking sector, where banks underestimate sovereign risk and the risk of a severe economic crisis. We analyse the quantitative consequences of financial regulations for the economy and the implications for welfare. Specifically, we assess how financial regulation can correct capital misallocations and how banks respond to changes in risk weights....

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