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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

No 89, ESRB Working Paper Series from European Systemic Risk Board

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 may be ineffective in reducing portfolio risk, including tail risk. JEL Classification: G01, G11, G21, G28

Keywords: bank regulation; diversification; home bias; sovereign-bank nexus; sovereign risk (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-eec and nep-rmg
Date: 2019-03
Note: 3546207
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Persistent link: https://EconPapers.repec.org/RePEc:srk:srkwps:201989

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