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The Effect of Possible EU Diversification Requirements on the Risk of Banks’ Sovereign Bond Portfolios

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  • Ben R. Craig
  • Margherita Giuzio
  • Sandra Paterlini

Abstract

Recent policy discussion includes the introduction of diversification requirements for sovereign bond portfolios of European banks. In this paper, we evaluate the possible effects of these constraints on risk and diversification in the sovereign bond portfolios of the major European banks. First, we capture the dependence structure of European countries? sovereign risks and identify the common factors driving European sovereign CDS spreads by means of an independent component analysis. We then analyze the risk and diversification in the sovereign bond portfolios of the largest European banks and discuss the role of ?home bias,? i.e., the tendency of banks to concentrate their sovereign bond holdings in their domicile country. Finally, we evaluate the effect of diversification requirements on the tail risk of sovereign bond portfolios and quantify the system-wide losses in the presence of fire-sales. Under our assumptions about how banks respond to the new requirements, demanding that banks modify their holdings to increase their portfolio diversification may mitigate fire-sale externalities, but it may be ineffective in reducing portfolio risk, including tail risk.

Suggested Citation

  • Ben R. Craig & Margherita Giuzio & Sandra Paterlini, 2019. "The Effect of Possible EU Diversification Requirements on the Risk of Banks’ Sovereign Bond Portfolios," Working Papers 19-12, Federal Reserve Bank of Cleveland.
    • Handle: RePEc:fip:fedcwq:191200
    DOI: 10.26509/frbc-wp-201912
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    Cited by:

    1. Rancan, Michela & Cariboni, Jessica & Keasey, Kevin & Vallascas, Francesco, 2023. "Bond issuance and the funding choices of European banks: The consequences of public debt," Journal of Empirical Finance, Elsevier, vol. 74(C).
    2. Ambrocio, Gene & Gu, Xian & Hasan, Iftekhar & Politsidis, Panagiotis N., 2022. "The diplomacy discount in global syndicated loans," Journal of International Money and Finance, Elsevier, vol. 120(C).
    3. Ben R. Craig & Margherita Giuzio & Sandra Paterlini, 2019. "The Effect of Possible EU Diversification Requirements on the Risk of Banks’ Sovereign Bond Portfolios," Working Papers 19-12, Federal Reserve Bank of Cleveland.
    4. Sam Langfield, 2020. "Bridge over Troubled Monetary Union: A Reply to De Grauwe & Ji," Journal of Common Market Studies, Wiley Blackwell, vol. 58(S1), pages 1-10, September.

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    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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