Is sovereign risk properly addressedby financial regulation?

D. Nouy

Financial Stability Review, 2012, issue 16, 95-106

Abstract: The treatment of sovereign risk in banking and insurance regulations has been highlighted by the sovereign debt strains affecting most advanced economies. In particular, it has become key to assess whether these regulations require from financial institutions to hold adequate regulatory capital associated with sovereign exposures. More broadly, although the main issue raised by the sovereign debt crisis is related to fiscal policies and consolidation, one crucial question is to determine how and to what extent financial regulation can help to mitigate and prevent vulnerabilities of the financial sector to sovereign risk. From this perspective, it appears that current regulatory framework does not require from financial institutions to hold significant regulatory capital against sovereign risk, inadequately assuming sovereign debt as a low-risk and even a risk-free asset class. Furthermore, some regulatory initiatives, while globally enhancing standards, could create further incentives to encourage financial institutions to hold sovereign debt. In addition to considering better reflection of sovereign risk in fi nancial regulation, supervisory practices also appear as a crucial tool to address the issue of heightened sovereign risk and its potential impact on financial stability.

Date: 2012
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