Ignazio Visco: Banks' sovereign exposures and the feedback loop
between banks and their sovereigns
Concluding remarks by Mr Ignazio Visco, Governor of the Bank of Italy, at the conference
"Euro50 Group. The Future of European Government Bonds Markets", Rome, 2 May 2016.
* * *
An intensely debated topic in the context of possible further financial reforms, in Europe and
internationally, concerns possible actions to address the negative loop between sovereign
risk and bank risk. The sovereign-bank nexus was one of the main amplifying factors of
financial distress during the euro area crisis. Banks' difficulties affected sovereigns directly,
through the bailout of troubled intermediaries, and indirectly, through the impact of the
disruption of lending on the economy. Sovereigns' difficulties affected banks' ratings, funding
costs, and balance sheets, while the recession worsened their lending portfolios.
Before the euro-area sovereign debt crisis, sovereign defaults were regarded as a problem of
emerging economies. Indeed, no advanced (OECD) country defaulted on its domestic debt
between 1950 and 2010.1 Therefore, it is not surprising that virtually all national supervisory
authorities have exercised the regulatory option to exempt banks' exposures to their
domestic sovereign, denominated and funded in domestic currency, from the standard
prudential banking regulation. These exposures are de facto subject to no concentration
limits and to a zero risk weight regime.
Following the recent euro-area sovereign debt and banking crises, it has been argued that
this preferential prudential treatment should be amended. Interestingly, this debate is not
new. Initially it took place in the early eighties, when Basel I was crafted. Reaching a
consensus on the framework was difficult. Two proposals were eventually tabled,
recommending a 20 percent risk- weight on domestic sovereign exposures, and a zero-risk
weight, respectively. Eventually the solution to apply a zero-risk weight was chosen,
apparently without any empirical analysis.2 A key role in the choice was played by the
recognition of the crucial role of sovereign bonds and securities in the functioning of financial
markets, with the aim of fostering the development of local bond markets, and the desire to
avoid interference with fiscal policy and monetary policy.
In the current debate, possible options range from the "baseline option", i.e. keeping the
current framework unchanged for exposures to the domestic sovereign, to assigning these
exposures a non-zero risk weight and/or subjecting them to concentration limits.3
Those who advocate changing the current framework argue that assigning banks' sovereign
exposures a non-zero risk weight increases capital and thus the resilience of the banking
system. Similarly, introducing rules to discourage a high concentration of sovereign
exposures would increase banks' chances of surviving a sovereign default, preventing them
from playing a "shock amplifier" role, as in recent cases of distress of sovereigns with weak
economic fundamentals.4 Furthermore, if risk weights accurately reflect sovereign risk, they
can incentivise banks' risk management of sovereign exposure by recognising that the higher
return from riskier counterparties comes at a cost of increased incurred risk. Also, in case a
crowding out of private lending by public debt exists, a risk sensitive approach for sovereign
risk could reduce this effect and promote the more efficient allocation of resources, leading to
higher investment and higher potential GDP growth.
Advocates of the "baseline option" also advance several arguments.
First, this option does not really mean "no change", as recent amendments of the regulatory
and legal framework have already made substantial progress towards breaking the
banksovereign loop. In Europe, the banks-to-sovereign causal link has been addressed by
bankrelated reforms, beginning with the BRRD. On the prudential front, banks' sovereign
exposures are taken into consideration in the capital exercise and stress test frameworks
applied since the end of 20115 - the results of which are nowadays taken into account in the
Pillar 2 capital buffers required within the SREP - and through the forthcoming introduction of
the leverage ratio. Furthermore, the European fiscal framework has been enhanced across
several dimensions, thus addressing the sovereign-to-bank nexus: the Stability and Growth
Pact has been amended, reinforcing both its preventive and its corrective arm; member
countries have strengthened their national budgetary processes and institutions; and a
surveillance mechanism has been set up for early detection and correction of
macroeconomic imbalances. Finally, the European Stability Mechanism was established.
Second, tightening regulatory standards on sovereign exposures can hardly be sufficient to
safeguard banks against their domestic sovereign default. Direct exposures are just one of
the channels that transmit sovereign risk to the domestic banking system. Sovereign defaults
are associated with severe economic crises, which have a widespread negative impact on
domestic banks quite independently from the degree of their direct exposure.6
Third, preventing an excessive concentration of risks may be desirable in principle. However,
the historical experience shows that in a "normal" economic environment EU banks
autonomously reduced their sovereign portfolios (as well as the concentration) without any
need for regulatory nudges (Fig. 1). Indeed, the evidence suggests that most EU countries'
sovereign holdings behaved counter-cyclically: they declined during the "normal period"
between the introduction of the euro and the beginning of the financial crisis; increased
during the crisis period; and started once more to decline in the last two years, as the crisis
began to subside (see the cases of Italy - Fig. 2 - and Spain).7 This pattern suggests that
regulation is not an important driver of banks' exposures towards their own sovereign:
throughout this entire period, the prudential treatment of sovereign exposures remained
broadly unchanged. It also indicates that high sovereign exposures are a symptom and a
consequence, rather than a driver, of the crisis.8
Fourth, whereas in "normal" times banks' sovereign exposures declined spontaneously, the
imposition of risk weights or - worse - tight concentration limits could create substantive
difficulties in "crisis" times. They could be particularly disruptive for banks' ability to act as
shock absorbers in the event of sovereign stress. There is evidence that sovereign debt
markets are prone to self-fulfilling crises: if investors believe a sovereign faces fiscal
problems, required yields will be higher, which can exacerbate, or even create, the fiscal
problems.9 Probably the clearest recent example of this pattern is the surge in
"redenomination risk" in the euro area, connected with undue fears of a break-up of the
Monetary Union. To the extent that banks act as contrarian investors (selling assets when
markets overheat and buying when they are excessively bearish), purchases of sovereign
debt when the sovereign experiences difficulties notwithstanding relatively solid economic
fundamentals are actually beneficial to financial stability. There is clear evidence that
domestic investors played such contrarian role during the EU sovereign debt crisis, buying
sovereign bonds as foreign investors were fleeing (Fig. 2 again for the Italian case; similar
patterns have been documented for Spain).10
Imposing risk weights or setting large exposure limits on domestic sovereign exposures
would impair this shock-absorption ability. Exposure limits, in particular, could act as a
coordinating device for speculative attacks. Since a change in banking regulation would likely
herald a similar change in other parts of the financial system (most notably the insurance
sector), the entire domestic financial sector could be affected.
Finally, a system which differentiates the risk weights according to the sovereign's credit risk
could end up relying upon ratings issued by the Credit Rating Agencies (CRA). Even
advocates of a change in the prudential treatment of sovereign exposures admit that credit
ratings of sovereigns have serious shortcomings. In particular, they tend to be
backwardlooking and to foster herd behaviour. As such, they could exacerbate pro-cyclicality and
ultimately increase financial instability risk.
Overall, I believe that today, as 30 years ago, the mere recognition that there is no truly
riskfree asset does not per se warrant a change in the regulatory treatment of sovereign
exposures. I doubt that further changes in prudential regulation are the right instrument for
addressing the sovereign- bank nexus, taking into account that sovereign risk should first
and foremost be addressed by strengthening the sustainability of public finances. In this
regard, while member states should attain sound fiscal positions so as to make their
sovereign paper safer, enhancing economic growth represents the most important factor for
putting the public finances on a sustainable path.
This is clearly shown by the example of Italy, where the debt to GDP ratio has risen by
33 percentage points since 2007. Back-of-the-envelope calculations show that if Italian
nominal GDP had since grown at a similar rate as in the previous ten years, the debt to GDP
ratio would now be just 3 points, and not 33 points, higher than in 2007 (actually, it would be
slightly below the 2007 level, once the financial support to other European countries is taken
into account).11 This suggests that efforts to rebalance the public finances must be part and
parcel of an economic policy designed to create the conditions for robust and lasting growth.
I also believe that any reform proposal should be based on a comprehensive approach,
avoiding partial equilibrium analyses and capturing all the relevant effects; also, it should be
evaluated by focusing on potential benefits and costs in a financial stability perspective,
taking into account potential unintended consequences. Considering the pervasive role
played by sovereign bonds in modern economies, these can arise in various sectors, well
beyond banking.
To this end, a deep understanding is needed of: the extension and potential effect of any
reallocation of bank sovereign exposures across banks; the interactions with other rules of
the Basel framework, including in particular the rules on liquidity; the impact of changes in
regulation on the provision of loans to the broader economy; the consequences for monetary
policy; the effects on the functioning of sovereign debt markets and on governments'
financing conditions; the impact on other financial market segments.
Several of these issues are being investigated at the BIS and also at the EU level, within the
European Systemic Risk Board and the Economic and Financial Committee. The impact on
market liquidity has been examined in this conference. Changes in the current prudential
framework leading to stricter capital requirements on sovereign bonds could incentivise
banks to further reduce the two pillars of market-making: sovereign bond inventories and
repo activities, which are eroding liquidity in secondary markets.
The effects of a regulatory change requiring substantive bank recapitalisations could be
destabilising in the transition phase, as it would entail a temporary but negative impact on
credit to the economy - an important effect, in the presence of stubbornly low nominal growth
and deflation risk. Such an effect is hard to capture analytically, as non-linearities are
possible, especially in the presence of financial tensions, and multiple equilibria cannot be
excluded. Envisaging a long transition period is unlikely to help, as market participants will
probably respond immediately by front-loading future changes in regulation, in order to
exploit "first mover" advantages.
Ratings have important drawbacks, but practical alternatives are hard to find. If the decision
is eventually taken to adopt risk weights on sovereign exposures, mechanisms based on
fiscal sustainability indicators, such as those computed by the EU Commission or by the IMF
could be considered as an alternative to - or in a suitable combination with - credit ratings.12
To conclude, the debate on changing the prudential regulation of sovereign exposures was
prompted by the recognition that "sovereign debt is not risk-free". There is no doubt that this
is true. However, at the current stage a broad agreement has been reached on the pros and
cons of different reform options, not on their overall balance. My personal view is that the
potential benefits of a reform are uncertain, while the potential costs could be sizeable. Be
that as it may, as long as such a balance remains uncertain, a prudent stance would be to
wait for the financial system to fully recover and adapt to the important set of reforms
implemented since the onset of the crisis, before making further changes. This would be
consistent with the approach chosen by the Governors and Heads of Supervision in their
recent statement that new regulatory reforms should "not significantly increase overall capital
requirements".
Note: Foreign holders, alternative definition: foreign holders excluding
Eurosystem and round-trip foreign portfolios and funds, i.e. securities held
by foreign investors net of those held by the Eurosystem (excluding the
Bank of Italy) and those held by foreign individually managed portfolios and
investment funds but attributable to Italian investors.