“ the impact of sovereign credit risk on bank funding conditions ”, bis, cgfs papers, no. 43. lanotte, m., g. manzelli, a. m. rinaldi, m. taboga and p. tommasino ( 2016 ), “ easier said than done? reforming the prudential treatment of banks ’ sovereign exposures ”, banca d ’ italia, questioni di economia e finanza ( occasional papers ), 326. angelini p., g. grande and f. panetta ( 2014 ), “ the negative feedback loop between banks and sovereigns ”, questioni di economia e finanza ( occasional papers ), 213, banca d ’ italia. bis central bankers ’ speeches 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 - cyclic

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 ”. european commission, directorate general for economic and financial affairs ( 2012 ), fiscal sustainability report, european economy, no. 8 ; imf ( 2014 ), fiscal monitor, april ; lanotte et al ( 2016 ), cit. bis central bankers ’ speeches 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. bis central bankers ’ speeches