Regulating the Doom Loop
86 Pages Posted: 13 Sep 2019
Date Written: September, 2019
Euro area governments have committed to break the doom loop between banks and sovereigns.But policymakers disagree on how to treat sovereign exposures in bank regulation. Our contributionis to model endogenous sovereign portfolio reallocation by banks in response toregulatory reform. Simulations highlight a tension between concentration and credit risk inportfolio reallocation. Resolving this tension requires regulatory reform to be complementedby an expansion in the portfolio opportunity set to include an area-wide low-risk asset. Byreinvesting into such an asset, banks would reduce both their concentration and credit riskexposure.
Keywords: Bank regulation, sovereign risk, systemic risk
JEL Classification: G01, G11, G21, G28
Suggested Citation: Suggested Citation