The regulatory precondition to sovereign risk transmission

This paper examines the role of regulation on how sovereign risk shocks affect bank balance sheets using a panel local projection approach and a newly created dataset of sovereign risk shocks for a sample of Eurozone banks. The empirical results show the existence of a regulatory precondition to sovereign risk transmission: banks that receive a favorable regulatory treatment in the form of a zero percent risk weight tend to increase home sovereign debt holdings and decrease lending in response to sovereign risk shocks. In contrast, comparable banks that face a stricter regulatory treatment, which requires them to calculate positive risk weights, do not exhibit this behavior. The results suggest that reforming the regulatory treatment of sovereign debt could mitigate the transmission of sovereign risk to bank balance sheets.

Keywords: Banks; Government Policy and Regulation; Sovereign Debt
JEL codes G21; G28; H6

Working paper no. 834