The Regulatory Precondition to Sovereign Risk Transmission
Research Highlights
- Does regulation affect the transmission of sovereign risk shocks to bank balance sheets?
- Banks that benefit from a 0% risk weight due to an exemption (called PPU) increase home sovereign bond holdings and decrease lending in response to sovereign risk shocks.
- Banks that do not benefit from the (PPU-)exemption and are required to calculate positive risk weights for home sovereign debt, do not show this behaviour.
- Regulation plays a crucial role in enabling the transmission of sovereign risk to bank balance sheets.
Abstract
This paper examines the role of regulation on how sovereign risk shocks affect bank balance sheets using a panel local projection approach and a newly created dataset of sovereign risk shocks for a sample of Eurozone banks. The empirical results show the existence of a regulatory precondition to sovereign risk transmission: banks that receive a favourable regulatory treatment in the form of a zero percent risk weight tend to increase home sovereign debt holdings and decrease lending in response to sovereign risk shocks. In contrast, comparable banks that face a stricter regulatory treatment, which requires them to calculate positive risk weights, do not exhibit this behaviour. The results suggest that reforming the regulatory treatment of sovereign debt could mitigate the transmission of sovereign risk to bank balance sheets.
Keywords: Banks · Government Policy and Regulation · Sovereign Debt
JEL codes: G21, G28, H6