Dokument: The Preferential Sovereign Bond Treatment in Bank Regulation

Titel:	The Preferential Sovereign Bond Treatment in Bank Regulation
URL für Lesezeichen:	https://docserv.uni-duesseldorf.de/servlets/DocumentServlet?id=51334
URN (NBN):	urn:nbn:de:hbz:061-20191028-093807-9
Kollektion:	Dissertationen
Sprache:	Englisch
Dokumententyp:	Wissenschaftliche Abschlussarbeiten » Dissertation
Medientyp:	Text
Autor:	Sterzel, André [Autor]
Dateien:	[Dateien anzeigen] Adobe PDF [Details] 1,67 MB in einer Datei [ZIP-Datei erzeugen] Dateien vom 22.10.2019 / geändert 22.10.2019
Beitragende:	Prof. Dr. Neyer, Ulrike [Gutachter] Prof. Dr. Börner, Christoph J. [Gutachter]
Dewey Dezimal-Klassifikation:	300 Sozialwissenschaften, Soziologie » 330 Wirtschaft
Beschreibung:	During the global financial crisis of 2008/2009 and the subsequent European sovereign debt crisis, significant contagion effects between sovereigns and banks could be observed. In some Member States of the European Union (EU) it was a serious banking crisis which forced governments to bail out troubled systemically important banks in order to avoid a collapse of the financial system. High bank bailouts thus strained public finances and, for example, in Ireland it caused a severe sovereign debt crisis (Frisell, 2016). In other EU countries serious doubts about the sovereign solvency put pressure on banks' balance sheets as domestic banks are one of the largest creditors of their national sovereigns. Risk transmission in this direction was shown in Greece where the sovereign debt crisis caused instability in the domestic banking sector (Navaretti et al., 2016, p. 9). The contagion effects from sovereigns to banks and vice versa can reinforce each other, also referred to as the "sovereign-bank nexus". This vicious circle became a threat to financial and macroeconomic stability in the EU. In the aftermath of the crisis several reforms have been discussed in order to mitigate the sovereign-bank nexus. One of the most well-known reforms is the European Banking Union, consisting of three pillars: The Single Supervisory Mechanism (SSM), the Single Resolution Mechanism (SRM) and the European Deposit Insurance (EDIS). So far, two of the three pillars, namely the SSM and the SRM have been legally implemented in the EU. However, the European Banking Union covers only one side of the sovereign-bank doom loop, it hence aims to avoid risk transmission from banks to sovereigns. Against this background, other reforms have also been introduced which should work to reduce the probability of sovereign distress and thus the potential contagion of risks from sovereigns to banks. These reforms include, for example, the European fiscal pact with the aim to strengthen the budgetary discipline, or the European Stability Mechanism (ESM) which acts as a backstop lender for EMU countries facing financial difficulty (Frisell, 2016, p. 109 f.). With respect to banking regulation, in the Basel Accords and in the EU legislative framework the risk of a potential sovereign default is still not considered. In particular, there are several areas in which sovereign bonds receive favourable treatment compared to other asset classes, most notably in three fields of bank regulation (Basel Committee on Banking Supervision, 2017): (i) for government bonds funded and denominated in the domestic currency a preferential risk weight is applied under the risk-based capital framework, (ii) sovereign exposures are exempted from the large exposure requirement, and (iii) government bonds are categorised as highly liquid assets within the liquidity regulation framework. To mitigate risk transmission from sovereigns to banks, some economists advocate in favour of abolishing the preferential sovereign bond treatment in bank regulation (see, for example, Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (2018, p. 246 ff.)). Weidmann (2016), the President of the Deutsche Bundesbank, emphasises that: "There is one field of regulation, however, where too little has been done so far - the treatment of sovereign exposures in banks' balance sheets. A banking system can only truly be stable if the fate of banks does not hinge on the solvency of their national sovereigns. Thus, I have been advocating, for quite some time now, a phasing-out of the preferential treatment of sovereign borrowers over private debtors". Against this background, all three papers of this thesis deal with the preferential sovereign bond treatment in banking regulation. In the first paper, facts concerning the preferential sovereign bond treatment are outlined, whereas in the second and third paper the effects of repealing the sovereign carve-out in bank regulation are theoretically investigated. In what follows the content of the papers are briefly described. The first paper, Reforming the Regulatory Treatment of Sovereign Exposure in Banking Regulation, adds to the existing literature in two ways. First, it gives an overview of facts which highlight the systemic risk associated with the existing preferential sovereign bond treatment in bank regulation. Second, it describes and discusses problems of three regulatory reforms dealing with the abolishment of the favourable sovereign bond treatment. The paper starts with a description of the sovereign bond regulatory treatment under the existing Basel Accords. The term "sovereign risk" is then defined and there is an assessment of whether the categorisation of sovereign bonds of the European Monetary Union (EMU) as being risk-free and highly liquid is justified. It is shown in the paper that sovereign bonds from the EMU are not per se risk-free. Hence, neglecting sovereign risk in bank regulation can be an issue for the stability of the banking sector (systemic risk). Since the start of the economic crisis in 2008, it could be observed that in particular in stressed euro area countries banks have significantly increased their sovereign holdings, and their home bias in sovereign bond holdings is the highest (with the exception of Ireland) compared to banks in non-stressed euro area countries. In order to explain this bank behaviour, it is analysed why banks hold sovereign bonds in normal times and which incentives banks might have to increase their domestic sovereign exposures when the risk of a sovereign default increases. Furthermore, the main contagion channels through which sovereign distress can affect the banking sector are summarised. Finally, the following three regulatory reforms addressing the recognised systemic risk associated with the regulatory treatment of sovereign exposures are discussed: (i) capital requirements for government bonds, (ii) large exposure limits for sovereign debt, and (iii) haircuts for sovereign bonds in liquidity regulation. The discussion focusses on the potential impacts of the reforms for the banking sector and financial stability. One of the main results is that all reforms would lead to large adjustments in banks' balance sheets, however, only two of the three reforms, namely capital requirements for government bonds and sovereign exposure limits, would be able to make banks more resilient to sovereign risk. The second paper, Capital Requirements for Government Bonds - Implications for Bank Behaviour and Financial Stability (co-authored by Ulrike Neyer), analyses the effects of backing government bonds with equity capital for banks and financial stability within a theoretical model. The model is based on Allen and Carletti (2006). In the centre of the model is a banking sector that is raising deposits from risk-averse consumers (depositors). The aim of the banking sector is to maximise their depositors' expected utility. As the depositors have the usual Diamond-Dybvig preferences, banks face idiosyncratic liquidity risk. In order to maximise the depositors' utility, banks can invest in three types of assets: in two liquid assets, a short-term asset and a risky government bond, and in one illiquid but highly profitable asset: a loan portfolio. Investing in the short-term asset and in government bonds allows banks to deal with the idiosyncratic liquidity risk. Besides deposits, banks can also finance their investments with equity capital from risk-neutral investors. Raising costly equity capital allows banks to transfer the liquidity risk associated with an investment in highly profitable loans from the risk-averse depositors to the risk-neutral investors, which increases the depositors' expected utility. Within this model setup we then analyse how banks change their investment and financing behaviour under two different capital regulation scenarios. We introduce capital requirements in the form of a risk-weighted capital ratio, requiring banks to back risky assets with equity capital. In the first regulation scenario, government bonds receive preferential treatment in the sense that banks do not have to set aside equity for their sovereign holdings. In the second regulation scenario, the preferential sovereign bond treatment is repealed, so that banks also have to back sovereign exposure with some equity capital. Comparing the two regulation scenarios shows that if not only loans but government bonds also have to be backed with equity capital, i.e. if the preferential treatment of sovereign exposures is repealed, banks will increase their loan-to-liquid asset ratio and they will increase their amount of equity capital. In a second step, we then investigate the banking sector's shock-absorbing capacity and hence its stability when sovereign risk increases under the two capital regulation scenarios. It is shown that a sudden increase in sovereign default risk may lead to severe liquidity issues in the banking sector. The reason is that banks hold sovereign bonds to deal with the liquidity risk. An increase in sovereign risk can lead to a price drop for sovereign bonds, inducing liquidity issues for banks. Our model reveals that capital requirements for government bonds are not able to prevent liquidity issues in the banking sector and thus do not contribute to a more resilient banking sector in times of sovereign distress. However, in combination with a central bank acting as a lender of last resort (LOLR), this regulatory change can increase the shock-absorbing capacity of the banking sector. The central bank then provides liquidity to illiquid but per se solvent banks against adequate collateral - in our model loans. The regulation-induced change in bank investment behaviour, i.e. the increase in the loan-to-liquid asset ratio of banks, yields that banks have more adequate collateral to obtain additional liquidity from the central bank relative to the additional liquidity needs caused by the sovereign bond price drop. As a result, with a LOLR, capital requirements for government bonds make the banking sector more resilient to sovereign risk. The third paper, Preferential Treatment of Government Bonds in Liquidity Regulation - Implications for Bank Behaviour and Financial Stability (co-authored by Ulrike Neyer), analyses the impact of different treatments of government bonds in bank liquidity regulation on bank behaviour and financial stability. In the same model setup as in the second paper, we explain in a first step how banks make their investment and financing decisions in two different liquidity regulation scenarios. The design of the liquidity ratio in our model captures the Liquidity Coverage Ratio (LCR) as it requires banks to back potential short-term liquidity withdrawals with a specific amount of liquid assets. In a first regulation scenario, there is a preferential sovereign bond treatment, meaning that sovereign bonds and the short-term asset are considered to be equally liquid although there exists a potential market liquidity risk for government bonds. In response to this required liquidity ratio, banks increase their amount of liquid assets (government bonds and the short-term asset) at the expense of loan investment and a reduction in equity capital. In a second regulation scenario, the preferential sovereign bond treatment in liquidity regulation is repealed, meaning that the potential market liquidity risk of sovereign exposures is taken into account by the regulator. Under this liquidity regulation framework sovereign bonds are considered to be less liquid than the short-term asset. In response to this changed required liquidity ratio, the observed bank behaviour as under the first regulation scenario is reinforced, i.e. banks increase their amount of liquid assets at the expense of loan investment and they reduce their amount of equity capital. The reason is that when sovereign bonds are assigned as being less liquid than the short-term asset, banks need even more liquid assets to fulfil the required liquidity ratio. However, the regulation has no effect on the banks' optimal composition of liquid assets, i.e. the ratio of the investment in the short-term asset relative to the investment in government bonds. Note that this optimal composition of liquid assets allows banks to fully hedge their idiosyncratic liquidity risk. Hence, in order to maintain the optimal ratio between the short-term asset and government bonds, banks have to increase their investments in both asset classes. In a second step, we then investigate the banking sector's shock-absorbing capacity under the two different liquidity regulation scenarios. As in the second paper, we show that a sudden increase in sovereign default risk may lead to liquidity issues in the banking sector, implying the insolvency of a significant number of banks. Liquidity requirements do not increase the resilience of the banking sector in the case of sovereign distress. To prevent banks from going bankrupt due to liquidity issues, a central bank acting as a LOLR is necessary. Then, introducing liquidity requirements in general and repealing the preferential treatment of government bonds in liquidity regulation in particular actually undermines financial stability. The reason is that the increase in government bond holdings increase the additional liquidity needs of banks after the shock and the decrease in loan investment leads to a decrease in the additional liquidity provision by the central bank. This regulation-induced change in bank investment behaviour makes banks more vulnerable to sovereign risk.
Lizenz:	Urheberrechtsschutz
Fachbereich / Einrichtung:	Wirtschaftswissenschaftliche Fakultät » Volkswirtschaftslehre
Dokument erstellt am:	28.10.2019
Dateien geändert am:	28.10.2019
Promotionsantrag am:	17.06.2019
Datum der Promotion:	30.09.2019