Korte, J. & Steffen, S. (2014) “A ‘sovereign subsidy’ – zero risk weights and sovereign risk spillovers“, VoxEU Organisation, 07 September.
European banking regulation assigns a risk weight of zero to sovereign debt issued by EU member countries, making it an attractive investment for European banks. This column defines a ‘sovereign subsidy’ as a new measure quantifying to what extent banks are undercapitalised due to the zero risk weights. Using recent sovereign debt exposure data, the authors describe the build-up of this subsidy for both domestic and cross-country exposures.
Motivation
Policymakers and academics have recently started to address severe distortions caused by the way banks are regulated in Europe. One of the most apparent flaws in banking regulation is the general application of zero risk weights for sovereign exposures.1 In general, Basel capital requirements stipulate that banks have to hold capital for all asset classes either based on a given regulatory risk weight or based on internally modelled default probabilities. However, this key idea of the Basel Accord has not been followed in the Capital Requirements Directive (CRD) of the European Union. Consequently, EU banks usually employ a zero risk weight for sovereign debt and thus do not hold capital against any of the sovereign exposures to EU member states.2
This regulatory treatment of sovereign debt contradicts the spirit of the Basel accords (Hannoun 2011, Nouy 2012). More importantly, it makes investments in risky sovereign debt particularly attractive (Acharya and Steffen 2013, Battistini et al. 2013). If sovereign risk materialises (as happened in the European sovereign debt crisis), banks might experience a substantial capital shortfall and might even require capital backstops by their domestic sovereigns.
We quantify the dimension of capital savings due to zero risk weights. Moreover, we discuss the economic implications associated with this regulatory treatment as it is an important determinant of the co-movement of sovereign CDS spreads within the Eurozone.
Relevant posts:
- Laeven, L. & Ratnovski, L. (2014) “Corporate governance of banks and financial stability“, VoxEU Organisation, 21 July.
- Micossi, S. (2014) “Bail-in rules in EU banking union and financial stability“, VoxEU Organisation, 05 June.
- Ignatowski, M. & Korte, J. (2014) “Resolution threats and bank discipline“, VoxEU Organisation, 20 May.