Bank capital regulation and the sovereign-bank nexus: evidence from European banks

Bonds issued by member states of the European Union benefit from privileges in banking regulation throughout all risk categories. In contrast to the risk-based approach applied to other asset classes, they do not have to be backed by equity, can be fully financed by short-term, unstable funding sources, are treated as liquid as cash and are not subject to exposure limits, regardless of their actual riskiness. We explore the effects of these regulatory privileges on the co-variation between sovereign and bank sector credit risks—the so-called sovereign-bank nexus. Examining sovereign bond portfolios of large European banks between 2011 and 2020, we show that additional capital buffers stemming from non-zero sovereign risk weights would indeed weaken the sovereign-bank nexus and thus serve as a reasonable starting point for the future regulatory treatment of sovereign exposures. However, the effect of banks’ domestic sovereign exposures is state dependent on the level of sovereign risk and the sovereign-bank nexus is not strongest for banks with the highest risk-weighted sovereign exposures. As a result, the impact of capital requirements based on traditional risk-weighting schemes would be limited.