Banks’ sovereign exposures: in search of new rules

We examine the reform of the prudential treatment of banks’ sovereign exposures, with the purpose of introducing risk-sensitive capital charges and limiting the home bias. We consider six different options and measure their impact on the CET1 ratio of 82 banks from 10 euro-area countries, participating in the 2019 EBA EU-wide transparency exercise and subject to the ECB supervision. Our evidence shows that the BCBS (2017) proposal is the one with the most evenly distributed impact across countries, in terms of CET1 ratio decline. That proposal targets two goals, risk sensitivity and diversification, with two independent instruments: rating-based risk weights and concentration add-ons. As a consequence, it is the only one introducing an incentive for banks located in all countries, low rated and high rated ones, to reduce their home bias. Some proposals focus on one objective only: either risk sensitivity or diversification. Other ones introduce a heavy penalization for banks located in low rated countries, without addressing the home bias of banks located in high rated countries. Several options are prone to pro-cyclicality: we measure this effect by simulating the impact of a two-notch downgrading of high debt countries on the CET1 ratio of banks. Some relevant cross-country effects emerge from our analysis, due to the large cross-country exposures of a few intermediaries.