Bank Capital Regulation and the Sovereign-Bank Nexus: Evidence from European Banks

93 Pages Posted: 11 Oct 2021 Last revised: 17 May 2023

See all articles by Rainer Baule

Rainer Baule

University of Hagen

Oliver Beckmann

University of Hagen

Christian Tallau

Muenster University of Applied Sciences

Date Written: May 16, 2023

Abstract

Bonds issued by member states of the European Union benefit from privileges in banking regulation throughout all risk categories. In contrast to the risk-based approach applied to other asset classes, they do not have to be backed by equity, can be fully financed by short-term, unstable funding sources, are treated as liquid as cash and are not subject to exposure limits, regardless of their actual riskiness. We explore the effects of these regulatory privileges on the co-variation between sovereign and bank sector credit risks—the so-called sovereign-bank nexus. Examining sovereign bond portfolios of large European banks between 2011 and 2020, we show that additional capital buffers stemming from non-zero sovereign risk weights would indeed weaken the sovereign-bank nexus and thus serve as a reasonable starting point for the future regulatory treatment of sovereign exposures. However, the effect of banks’ domestic sovereign exposures is state dependent on the level of sovereign risk and the sovereign-bank nexus is not strongest for banks with the highest risk-weighted sovereign exposures. As a result, the impact of capital requirements based on traditional risk-weighting schemes would be limited.

Keywords: Sovereign-bank nexus, risk transmissions, sovereign exposures, zero risk weight, credit risk, liquidity risk, risk concentration, Basel II, Basel III, CRR, CRD, interaction effects in regression analyses, three-way interaction

JEL Classification: G21, G28

Suggested Citation

Baule, Rainer and Beckmann, Oliver and Tallau, Christian, Bank Capital Regulation and the Sovereign-Bank Nexus: Evidence from European Banks (May 16, 2023). Available at SSRN: https://ssrn.com/abstract=3939044 or http://dx.doi.org/10.2139/ssrn.3939044

Rainer Baule

University of Hagen ( email )

Universitaetsstrasse 41
Hagen, 58097
Germany

Oliver Beckmann (Contact Author)

University of Hagen ( email )

Universitätsstrasse 41
Hagen, 58097
Germany

Christian Tallau

Muenster University of Applied Sciences ( email )

Hüfferstraße 27
Münster, Münster 48149
Germany

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