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

Ben Craig (), Margherita Giuzio and Sandra Paterlini
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Margherita Giuzio: European Central Bank

No 191200, Working Papers from Federal Reserve Bank of Cleveland

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.

Keywords: Bank regulation; sovereign-bank nexus; sovereign risk; home bias; diversification (search for similar items in EconPapers)
JEL-codes: G01 G11 G21 G28 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-eec, nep-fmk and nep-rmg
Date: 2019-05-28
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedcwq:191200

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DOI: 10.26509/frbc-wp-201912

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