Diversifying sovereign risk in the Euro area: empirical analysis of different policy proposals

The 2010 sovereign crisis in the euro area brought to light the depth of the monetary union’s structural weaknesses. In particular, it highlighted the dangers of the sovereign-bank nexus – the amplification effect resulting from sovereign debt being held primarily by domestic banks. In response, important changes have been put in place. From a crisis management perspective, new institutions were created, such as the European Stability Mechanism which acts as a lender of last resort for euro area countries in difficulties. From an ex ante perspective, the crisis led to the launch of the banking union, which comprises the Single Resolution Mechanism – including the Single Resolution Fund – and the still-pending European Deposit Insurance Scheme. In addition, a wide array of regulation has been put in place, including Basel III and MREL/TLAC requirements to reduce the need for bailouts during financial crises and therefore limit the use of public funds in resolution processes. Despite this, the regulatory debate on how banking regulation should address this sovereign-bank interdependence continues today. In this paper we review the main regulatory proposals aimed at curtailing both exposure to sovereign risk and ownership concentration - two factors often associated to the broader sovereign-bank nexus. We assess their impact on bank capital and risk-weighted assets and simulate banks’ responses to these measures. We find that these solutions could entail significant side effects for both banks and bond markets, highlighting the importance of completing the monetary union and, in particular, issuing a European safe asset as key measures to mitigate this vulnerability.