09 November 2015

European Political Strategy Centre: Further Risk Reduction in the Banking Union

The European Commission’s in-house think tank released an issue of its Five President's report series regarding Banking Union, in which it said that a large exposure regime of euro area banks to their own sovereigns is the preferred policy option. If introduced, it would be placed with the ECB.

Conclusion

Largely reflecting EU and global policy choices, euro area banks are greatly exposed to their own sovereigns.

A straightforward exposure regime would greatly limit systemic risk in the banking system, result in a well-diversified government debt portfolio and considerably weaken the doom loop between sovereigns and their banking systems.25

A large exposure regime is the preferred policy option for the following reasons:

• it is a policy option that accounts for unforeseen events and addresses excessive counterparty risk,
• it is not a pro-cyclical measure,
• it incentivises a well-diversified government debt portfolio,
• it does not imply the renegotiation of global regulatory frameworks, so could be implemented directly by the EU (no ‘Basel 3.5’ needed for this). However, the option of a global reform should be pursued in parallel to ensure global convergence on this matter.

Any threshold would need to be carefully calibrated and account for the importance of the sovereign bond market for the functioning of wider capital markets and eventually for the funding of the real economy as well as of sovereigns. The exposure limit of 25% of own funds, as stipulated in the Capital Requirements Regulations, is unlikely to take these special circumstances adequately into account.

A large exposure regime, if introduced, would be placed with the ECB, the supervisory authority in the context of the Single Supervisory Mechanism. However, more wholesale changes in the regulatory framework (for instance, rethinking of the assessment of the riskiness of sovereign debt) would likely necessitate global discussions and agreements and should be pursued in the relevant international fora.

Full report

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