Article 89 (1) (d) of the Capital Requirements Directive of the European Banking Authority permits European domestic banks to assign a zero-risk weight for bank exposures to sovereigns issued by member states’ governments. While financial markets demand sizable risk premia on sovereign bonds of EU member states, banks are still allowed to treat the bonds as risk-free and assign a zero-risk weight in their books. The privileged treatment of European sovereign debt and the sovereign-bank nexus have stimulated a lively policy debate (see Schmidt et al. 2012 and Schnabel et al. 2016). Relatedly, large exposures to debt may lead to spillovers of public default risk in one country to another country (Steffen 2014). One proposal to alleviate the ‘deadly embrace’ between banks and the government is the introduction of risk weights on sovereign debt (Grande and Angelini 2014). These debates are also tightly connected to a much broader discussion on completing the capital market union and banking union as evidenced in a recent speech by Joachim Nagel (2024), president of the Deutsche Bundesbank.
Does a zero-risk weight impact capital misallocations and cause undesirable outcomes for the economy? Can positive risk weights on sovereign debt improve macroeconomic outcomes and financial stability? These are important questions for policymakers and a nascent academic literature on the sovereign-bank nexus. We contribute to this debate by assessing the implications of a zero-risk weight policy on sovereign debt. We contrast the results to an economy with positive risk weights and for different degrees of fiscal stress.
In our study (Fueki et al. 2024), we use a non-linear dynamic stochastic general equilibrium model with a banking sector, where banks underestimate sovereign risk and the risk of a severe economic crisis. We analyse the quantitative consequences of financial regulations for the economy and the implications for welfare. Specifically, we assess how financial regulation can correct capital misallocations and how banks respond to changes in risk weights.
Financial regulation, disaster risk, and expectation formation
Our benchmark is a real business cycle model with risky government debt. Investors demand risk premia when the economy approaches its fiscal limit (Bi 2012). In normal times, the economy faces conventional productivity shocks, but occasionally a disaster state materialises, where a fraction of the capital stock is destroyed (Gourio 2012). Banks operate for two periods following Arellano et al. (2024) and Coimbra and Rey (2024). Initially, equity is injected by households as start-up funds, while banks also collect deposits and pay a guaranteed return. Based on these funds, banks invest in loans to firms and into a portfolio of long-term government bonds.
In this setting, our primary friction introduces inefficiencies due to imperfect information: we assume that the representative household, and by direct extension the banks, which are managed by the household, assigns a too low probability to the future disaster state and to potential future fiscal stress. We justify this assumption by appealing to moral hazard and bad monitoring technology. Banks offer a guaranteed return on deposits, not properly considering the disaster state and where limited liability arises from deposit insurance. We assume that banks are overly optimistic about the probability of receiving a bailout from the government. In addition, banks and households misprice or underestimate risks concerning the disaster state. This myopia is then compounded by policy that applies zero-risk weights to sovereign debt, which pushes banks to over-accumulate sovereign debt relative to private capital. This channel forces the economy to deviate from first-best allocations.
Impulse responses to disaster shocks and risk weights
Figure 1 shows the impulse responses to a sequence of four disaster shocks for different risk weights ranging from 0% to 50%. Following a disaster shock, misallocations are much larger and more persistent under the zero-risk weight policy compared to the non-zero-risk weight policy. In the zero-risk weight economy, capital and output decline more strongly than in the economy with the highest risk weight on sovereign bonds. In addition, banks accumulate more sovereign debt in the zero-risk weight economy, which results in a higher debt-to-GDP ratio, higher sovereign yields, and a 50% probability of default, compared to only a 10% probability of default for the 50% risk weight. With a higher risk weight, fiscal stress and the sovereign-bank nexus are less pronounced.
Intuitively, following a disaster shock, misallocations are much larger and more persistent under the zero-risk weight policy vis-à-vis the non-zero-risk weight policy due to the negative feedback loop: Since the government needs to provide deposit insurance to help banks after the disaster shocks, the probability of sovereign default rises. The sovereign debt worsens the banking sector's balance sheet through declining sovereign prices, which also increases deposit insurance and reduces bank lending. This negative feedback loop leads to persistently slower recovery from disaster shocks. Finally, fiscal stress amplifies all our findings. The negative feedback loop is very sensitive to the sovereign's fiscal position. The extent to which the zero-risk weight policy leads banks to misprice sovereign debt increases as fiscal positions deteriorate, which further distorts the allocations of the banks' balance sheet.
Figure 1 Impulse responses to disaster shocks and financial regulation
Notes: This figure shows the impulse responses in percentage deviation from the stochastic steady state in response to a sequence of four disaster shocks for risk weights between 0% and 50% in increments of five percentage points. The default probability is shown in absolute terms.
Welfare results and financial regulation
The zero-risk weight policy exacerbates deviations from first-best allocations, while non-zero-risk weight policies move the economy much closer to first-best allocations. The zero-risk weight policy causes a substantial distortion that results in nearly 20% less capital in the stochastic steady state (relative to the first-best allocation) and a substantial reduction in welfare. The underlying mechanism works through the bank's balance sheet. Banks over-accumulate sovereign debt under the zero-risk weight policy at the expense of private capital.
Figure 2 shows how financial regulation affects welfare outcomes. In the left-hand panel we solve the non-zero-risk weight economy for different risk weights on government debt ranging from 0% to 50%, while other parameters are kept fixed to the baseline calibration. We calculate welfare relative to the zero-risk weight economy. Introducing risk weights on sovereign debt raises welfare by more than two percentage points relative to the zero-risk weight economy.
The right-hand panel shows how welfare responds in the non-zero-risk weight economy to changes in the capital requirement or retained earnings of the bank. Welfare in the non-zero-risk weight economy drops dramatically when the capital requirement is set to a low value. Welfare gains become negligible relative to the non-zero-risk weight economy at a retained earnings requirement of around 7%. Thus, if retained earnings are high enough, this particular regulation can offset misallocations due to the zero-risk weight on sovereign bonds. Recall that a zero-risk weight policy, whilst imposing a zero-risk weight on government bonds, still forces banks to hold equity against risky capital. These capital buffers serve to mitigate the fluctuations because, if the disaster state occurs, banks can use the retained earnings to repay deposits that were guaranteed assuming (incorrectly) the worst-case scenario was a ‘low’ technology shock. The upshot here is that mitigating business cycle dynamics can be partly achieved through zero-risk weight policies, although non-zero-risk weight policies fully achieve this goal while simultaneously improving first-moment allocations. Thus, some macroprudential policy is better than none.
Figure 2 Financial regulation and welfare
Notes: Panel (a) plots the change in welfare relative to the baseline zero-risk weight case as the risk weight on bonds increases. Panel (b) plots the percentage change in welfare as the capital requirement percentage increases relative to the baseline non-zero-risk weight.
Macroeconomic tail risk and financial regulation
Our global solution method allows us to shed light on the most extreme model outcomes. Figure 3 shows the worst-case and best-case outcomes in each period in the zero-risk weight economy and the non-zero-risk weight economy. The figure clearly depicts how the zero-risk weight policy can negatively impact the economy at all horizons. The macro aggregates (capital, debt-GDP ratio, and GDP) are substantially worse in the zero-risk weight economy in the worst-case simulations. The best-case simulations exhibit little difference. The main message from this exercise is: in good times, the differences between zero-risk weight and non-zero-risk weight policies are negligible but, in times of high fiscal stress, the zero-risk weight policy substantially distorts the economy and worsens macro aggregates.
Figure 3 Macroeconomic tail risk and financial regulation
Notes: This figure shows the impulse responses in %-deviation from the stochastic steady state in response to a sequence of four disaster shocks. Based on 20,000 simulations, we show the worst-case and best-case outcomes in each period in the zero-risk weight and non-zero-risk weight economy.
Conclusion
Financial institutions, especially in Europe, hold a disproportionate amount of domestic sovereign debt. In this column, we show how this home bias can arise and lead to capital misallocation in a real business cycle model with imperfect information and fiscal stress. A zero-risk weight policy provides an incentive for banks to hold sovereign debt over private capital. In our model, banks are assumed to miscalculate the probability of a disaster state due to moral hazard and imperfect monitoring. This distortion pushes the economy away from the first-best allocation. Moreover, as the economy approaches its fiscal limit, these distortions are amplified. The welfare costs associated with zero-risk weight policies are very large, while they are substantially smaller in the economy with positive risk weights. That said, some macroprudential policy is better than none.
Authors’ note: The views expressed in this column are exclusively those of the authors and do not necessarily reflect those of the Deutsche Bundesbank or the Eurosystem.
References
Arellano, C, Y Bai and L Bocola (2024), “Sovereign Default Risk and Firm Heterogeneity”, Staff Report, Federal Reserve Bank of Minneapolis, No. 547.
Bi, H (2012), “Sovereign default risk premia, fiscal limits, and fiscal policy”, European Economic Review 56(3): 389–410.
Coimbra, N and H Rey (2024), “Financial Cycles with Heterogeneous Intermediaries”, The Review of Economic Studies 91(2): 817–857.
Fueki, T, P Hürtgen and T B Walker (2024), “Zero-risk weights and capital misallocation”, accepted at Journal of Financial Stability.
Gourio, F (2012), “Disaster Risk and Business Cycles”, American Economic Review 102(6): 2734–2766.
Grande, G and P Angelini (2014), "How to loosen the banks-sovereign nexus", VoxEU.org, 8 April.
Nagel, J (2024), "Monetary union, capital markets union, banking union – a triad for Europe’s prosperity and resilience", Speech delivered at the 23rd German Banking Congress, 23 April.
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Steffen, S (2014), “A ‘sovereign subsidy’ – zero risk weights and sovereign risk spillovers”, VoxEU.org, 7 September.
