EU financial policymakers appear to be once more in a deadlock situation over proposals to limit the sovereign risk exposure of European banks. The strong exposure of some banks in the southern European periphery in their national sovereign’s debt was seen by many as one of the contributing factors to the ongoing sovereign debt crisis (Acharya et al. 2014, Beltratti & Stulz 2015; Brunnermeier et al. 2016). Powerful incentives have encouraged financial institutions to buy and hold government bonds in the past (Gros 2013). In fact, this was the intellectual background for the policy framework known as the Banking Union, which specifically aimed at untangling the close relationship and the “doom loop” between governments and their respective banking sector (Gordon & Ringe 2015).

Presently, Germany is pushing for the adoption of sovereign debt ceilings to strengthen banks’ balance sheets, and to reduce the risk to taxpayers in any future scenario where EU states need to rescue failing banks (see also Andritzky et al. 2016). Germany has de facto made this project a precondition for further talks on the introduction of a common EU deposit insurance system (EDIS). This position is grounded in the concern that unless banks are limited in the amount of their specific sovereign debt, governments will be able to use them to fund own-budget deficits, tempted in particular in circumstances in which protection for depositors will come through EDIS.

Italy is the main opponent to the proposal over fears that it could upset bond markets and banks’ financial stability (Politi & Brunsden 2016). Its objection is also motivated by the fact that in particular Italian banks hold large amounts of Italian national debt and may see the value of their holdings reduced if limits were imposed. Further, governments in the periphery would undoubtedly make it more expensive to fund themselves. Political agreement seems remote.

Against the backdrop of the present political impasse, it is frequently overlooked that the objective of limiting banks’ sovereign risk exposure can be readily achieved using the regulatory toolkit that is already in place. Introducing risk-weighing or risk limits would thus not be necessary (although they would still remain desirable).

A number of different channels are available. Rather than introducing general and abstract limits on the possibility to hold domestic sovereign debt or risk weight requirements, these channels rely on the assessment of individual banks’ risk profile and resolvability.

The most obvious way is individual banking supervision through the ECB. Via the Single Supervisory Mechanism (SSM), the ECB has direct responsibility for the Eurozone’s large banks and exercises a more indirect oversight for smaller banks. The SSM may come to the conclusion that individual banks’ risk profiles are not sufficiently diversified and too much dependent on the financial viability of the sovereign. The SSM’s monitoring regime includes conducting stress tests on financial institutions. Where it finds problems, it has the ability to conduct early intervention in the bank to rectify the situation, such as by setting capital or risk limits or by requiring changes in management.

Beyond the ECB’s reach, the ‘recovery and resolution planning’ review process under the EU-wide Bank Recovery and Resolution Direction (BRRD) may lead the national regulator to conclude that a high exposure in national sovereign debt may jeopardize the ‘resolvability’ of a particular financial institution. The regulator may then request remedial action.

Individual bank-based supervisory action instead of broad “one size fits all” exposure limits would have the additional benefit of allowing for individual exceptions or transition periods. These could be based on market stability concerns or individual banks’ weaknesses.

A properly run SSM would never have permitted a bank to concentrate assets in risky sovereign debt, so that the deterioration in a single sovereign’s credit rating would not have created the liquidity issues that many such banks now face. To be sure, large parts of the sovereign risk exposure pre-date the introduction of the SSM; this means that the latter must now gradually wean European banks off their governments. Any of the foregoing would have to be introduced gradually and with ample transition periods to give market participants time to adjust.

REFERENCES

1. Acharya, V. V., I. Drechsler and P. Schnabl (2014), “A Pyrrhic victory? Bank bailouts and sovereign credit risk”, Journal of Finance 69, pp. 2689-2739.
2. Andritzky, N. Gadatsch, T. Körner, A. Schäfer and I. Schnabel, “A proposal for ending the privileges for sovereign exposures in banking regulation”, VOX.
3. Beltratti, A. and R. M. Stulz (2015), “Bank Sovereign Bond Holdings, Sovereign Shock Spillovers, and Moral Hazard during the European Crisis”, NBER Working Paper No. 21150.
4. Brunnermeier, M., L. Garicano, P.R. Lane, M. Pagano, R. Reis, T. Santos, D. Thesmar, S. van Nieuwerburgh and D. Vayanos (2016), “The Sovereign-Bank Diabolic Loop and ESBies”, NBER Working Paper No. 21993.
5. Gordon, J. N. and W. G. Ringe (2015), “Bank Resolution in the European Banking Union: A Transatlantic Perspective on What It Would Take”, Columbia Law Review 115, pp. 1297-1369.
6. Gros, D. (2013). “Banking Union with a Sovereign Virus. The Self-serving Treatment of Sovereign Debt”, Intereconomics, pp. 93-97.
7. Politi, J. and J. Brunsden. 2016. ‘Italy pledges to block limit on sovereign debt holdings.’ Financial Times (19 February 2016), p. 6.

Jeffrey N. Gordon is Richard Paul Richman Professor of Law at Columbia Law School and Co-Director of the Millstein Center for Global Markets and Corporate Ownership. W. Georg Ringe is Professor of International Commercial Law at Copenhagen Business School and Visiting Professor at the University of Oxford.