The Zero Risk Fallacy - Banks' Sovereign Exposure and Sovereign Risk Spillovers
60 Pages Posted: 13 Feb 2014 Last revised: 12 Sep 2017
Date Written: August 28, 2017
European banks are exposed to a substantial amount of risky sovereign debt. The “missing bank capital” resulting from the zero-risk weight exemption for European banks for European sovereign debt amplifies the co-movement between sovereign CDS spreads and facilitates cross-border financial-crisis spillovers. Risks spill over from risky periphery sovereigns to safer core countries, but not in the opposite direction nor for exposures to countries not exempted from risk-weighting. We consider the trade-off of benefits of sovereign debt (for banks and sovereigns) and spillover risk when applying risk-weights. More bank capital as well as positive risk-weighting for sovereign exposures mitigates spillovers.
Keywords: sovereign debt, sovereign risk, spillovers, bank risk, CDS, zero risk weight exemption
JEL Classification: G01, G21, G28
Suggested Citation: Suggested Citation