The euro area faces  a year of opportunity for completing the job of fixing the flaws exposed by the past decade of banking and sovereign debt crisis. The crisis is almost certainly over, memories are still fresh, and complacency has not yet fully set in. The political timetable for 2018 is propitious: France is energized with a new government, Germany will probably have one soon, and elections are expected in Italy in March. After that, no major political upheaval is expected until the European parliamentary election in the spring of 2019. The economic recovery is robust and broad-based. As European Commission president Jean-Claude Juncker put it, there is a favorable wind in Europe’s sails.

The driving engine of the euro area crisis, as acknowledged in communications from mid-2012 onwards, was the vicious circle between banks and sovereigns. Eliminating this fragility must be the central objective of the post-crisis agenda. This goal can be achieved through a fiscal union, a banking union, or both. With Europe’s incomplete political integration, policymakers have preferred pursuing a banking union over the past five years as a more practical path than a fiscal union.

Euro area reforms should aim at completing the still-fledgling banking union, specifically by cutting the link between banks and the sovereign debts of their home countries. These links remain  excessive despite the (broadly successful) establishment of a Single Supervisory Mechanism and Single Resolution Mechanism in the past half-decade. The reforms should have the ultimate goal of ensuring that any future sovereign debt restructuring does not automatically trigger a banking panic, and that in turn, future large-scale banking crises do not trigger sovereign debt distress.

Concentrated sovereign exposures are at the center of bank-sovereign financial linkages. Most (though not all) euro area banks have disproportionate sovereign exposure to their home country, for reasons that remain debated but have not been substantially eroded in the last few years of recovery. This “home bias problem” is unique to the euro area, where banks can and should diversify their sovereign exposures away from their home country without incurring currency risk. Not only is the home bias problem a key element of the vicious circle, it also deters progress on removing another major element, namely the fact that deposit insurance remains national. This is because some member states fear (not unreasonably) that an integrated European Deposit Insurance Scheme (EDIS), as proposed two years ago by the European Commission, could be abused by some sovereigns to secure preferential funding from “their” banks, in the absence of safeguards against such “financial repression.” Thus, achieving EDIS involves a broader policy package that includes addressing the home bias problem.

As detailed in a study published last month by the European Parliament, this challenge can be met with a new regulatory regime that would discourage concentrated sovereign exposures. This proposed mandatory (or in the jargon of the Basel framework for banking supervision, “Pillar-one”) instrument would consist of sovereign concentration charges, working as follows. In the current calculation of a bank’s risk-based capital ratio, the denominator is the bank’s total risk-weighted assets, an aggregate from which sovereign exposures (which are generally assigned a zero credit-risk weight) are almost entirely exempted. Under the proposed design, a second component would be added to that denominator, consisting of sovereign exposures weighted by coefficients (the concentration charges) that are set at zero for smaller exposures but increase with the exposure ratio (defined as the bank’s sovereign exposure to any given euro area country, over its tier 1 regulatory capital) above an “exemption threshold” set at 33 percent in the proposed calibration.

This rather simple design ensures that euro area sovereign exposures are not charged for sovereign credit risk but only for concentration risk, echoing the specific nature of the euro area’s home bias problem. (Sovereign credit risk is a distinct and intrinsically treacherous issue, which is not particularly specific to the euro area and may in the future be addressed by the Basel Committee at the global level.) Correspondingly, only euro area sovereign exposures of euro area banks would enter the calculation of sovereign concentration charges. Assuming banks respond to incentives, and eventually diversify their sovereign exposures within the euro area so that all come under the exemption threshold, this would not result in any competitive distortions that would put euro area banks at a disadvantage to their peers, either in other EU countries or in the rest of the world. EDIS would be introduced in parallel with sovereign concentration charges, ensuring a proper balance of risk sharing and market discipline.

This proposal builds on earlier suggestions made by regulators, and presumably echoes recent nonpublic discussions in venues such as the EU Economic and Financial Committee’s 2016 high-level working group on the regulatory treatment of sovereign exposures, or the Basel Committee. It also goes further, by including specific proposals for calibration and transitional arrangements. The suggested calibration is adjusted so that exposures above 150 to 200 percent of a bank’s capital are effectively discouraged (so that the capital is not wiped out in a sovereign restructuring that can typically involve a haircut of up to 30 to 40 percent), while exposures under 50 percent are barely penalized (which leaves ample space for activities such as market-making on sovereign debt markets, and avoids forcing banks into diversification into too many countries). The following table summarizes the calibration and its impact on capital ratios (itself dependent on the bank’s tier 1 capital ratio, thus the two columns on the right).

Effect of proposed calibration on capital ratios
      Capital impact (basis pointsa)
Exposure ratio (percent) Marginal SCC
Average SCC
Tier 1 ratio = 10 percent Tier 1 ratio = 15 percent
50 15 5 -3 -6
100 30 18 -17 -38
150 50 28 -41 -90
200 50 34 -63 -138
250 100 47 -105 -225
300 100 56 -144 -301
350 200 76 -211 -430
SCC = sovereign concentration charge
a. one hundredth of a percentage point
Source: Author's calculations.

This impact would not be immediate, though. The study recommends a lengthy transition period, in which the sovereign concentration charges are phased in gradually, and moreover, any sovereign debt outstanding before the new legislation’s entry into force would be exempted from their calculation (or “grandfathered”). The combination of a mild calibration and cautious transition arrangements would ensure that this significant structural change can be introduced without causing any disruption in sovereign debt markets, and at a negligible cost to the banks themselves. Since EDIS also involves a long transition from the current national deposit insurance regimes, the two reforms could be decided together next year, and then unfold in parallel to reach a steady state in the late 2020s.

Sovereign concentration charges, combined with EDIS, would not be a panacea for the euro area’s ills, but could decisively break the current deadlock in the discussion over banking union. For more fragile countries, the Europeanization of deposit insurance, and the corresponding sharply reduced probability of a euro area break-up (or “redenomination risk”), would more than offset any negative impact of domestic banks losing their role in smoothing the impact of sovereign debt market stress (a “shock-absorbing” role which, in any case, stands fundamentally at odds with the very principle of banking union). For countries currently perceived as low risk, the sovereign concentration charges would reassuringly bolster market discipline and ensure that EDIS is not subverted by national financial repression. Furthermore, removing the current uncertainty over the future regulatory treatment of sovereign exposures would lift an obstacle to desirable cross-border banking consolidation. Every country would gain, as would the euro area as a whole.

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