The Effect of Possible EU Diversification Requirements on the Risk of Banks' Sovereign Bond Portfolios

Abstract

Recent policy discussion includes the introduction of diversification requirements for sovereign bond portfolios of European banks. In this paper, we evaluate the possible effects of these constraints on risk and diversification in the sovereign bond portfolios of the major European banks. First, we capture the dependence structure of European countries' sovereign risks and identify the common factors driving European sovereign CDS spreads by means of an independent component analysis. We then analyze the risk and diversification in the sovereign bond portfolios of the largest European banks and discuss the role of "home bias," i.e., the tendency of banks to concentrate their sovereign bond holdings in their domicile country. Finally, we evaluate the effect of diversification requirements on the tail risk of sovereign bond portfolios and quantify the system-wide losses in the presence of fire-sales. Under our assumptions about how banks respond to the new requirements, demanding that banks modify their holdings to increase their portfolio diversification may mitigate fire-sale externalities, but it may be ineffective in reducing portfolio risk, including tail risk.

Bridge over Troubled Monetary Union: A Reply to De Grauwe & Ji

“…Alogoskoufis and Langfield (2020) show that a necessary condition for the doom loop to be broken is for banks' sovereign portfolio diversification to be coupled with de‐risking, which requires that the pooled security (comprising government debt from all members of the euro area) benefits from some form of credit protection. Without credit protection, diversification into the pooled security could lead some banks to increase their credit risk exposure insofar as they substitute low‐risk for high‐risk debt (Craig et al ., 2020). Thus, in general equilibrium, pure diversification can give rise to cross‐country contagion in the spirit of Wagner (2010).…”