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

ESRB Working Paper No. 89 / March 2019

48 Pages Posted: 31 May 2017 Last revised: 29 Jul 2019

See all articles by Ben R. Craig

Ben R. Craig

Federal Reserve Bank of Cleveland; Deutsche Bundesbank

Margherita Giuzio

European Central Bank (ECB)

Sandra Paterlini

University of Trento - Department of Economics and Management

Date Written: March 20, 2019

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.

Keywords: Bank regulation; sovereign-bank nexus; sovereign risk; home bias; diversification

JEL Classification: G01, G11, G21, G28

Suggested Citation

Craig, Ben R. and Giuzio, Margherita and Paterlini, Sandra, The Effect of Possible EU Diversification Requirements on the Risk of Banks’ Sovereign Bond Portfolios (March 20, 2019). ESRB Working Paper No. 89 / March 2019 , Available at SSRN: https://ssrn.com/abstract=2976060 or http://dx.doi.org/10.2139/ssrn.2976060

Ben R. Craig

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101
United States
216-579-2061 (Phone)
216-579-3050 (Fax)

Deutsche Bundesbank

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Margherita Giuzio (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Sandra Paterlini

University of Trento - Department of Economics and Management ( email )

Via Inama 5
Trento, I-38100
Italy

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