Implications of the Regulatory Treatment of Sovereign Exposures for Bank Behavior

Abstract

Using bank-level sovereign exposures published by the European Banking Authority between 2011 and 2020, this paper empirically explores the development of sovereign bond holdings by European banks. The heterogeneity in exposure, bank and macroeconomic characteristics is then exploited to identify factors that determine a bank’s decision to invest in sovereign debt. Sovereign exposures build a sizable and stable share of banks’ balance sheets and exhibit a home bias that by far exceeds regulatory large exposure limits. On average, banks react to rising sovereign bond yields by purchasing sovereign debt. Consistent with regulatory arbitrage in terms of capital and liquidity, this yield-seeking behavior is more pronounced for less capitalized and less liquid banks. Contrarily, banks react similarly to the yield changes of sovereign counterparties located in the European Union compared to third countries, contradicting the idea that privileges for member states of the European Union in banking regulation alter banks’ behavior. Confirming the effect of moral suasion by the domestic sovereign, recently bailed-out and government-owned banks exhibit a stronger rise in their holdings of domestic sovereign bonds. Providing indirect evidence for the design of carry trades, periods of cheap refinancing possibilities reinforce yield-seeking behavior.

Keywords: sovereign exposures, sovereign bond yields, zero risk weight, credit risk, liquidity risk, risk concentration, Basel II, Basel III, CRR, CRD, regulatory arbitrage, moral suasion, carry trade

JEL Classification: G21, G28