Presentation by Jörg Rocholl, discussion led by Sam Langfield
Participants (alphabetical)
Jochen Andritzky German Council of Economic Experts
Roel Beetsma University of Amsterdam
Mathias Dolls ifo Institute
Daniel Gros Centre for European Policy Studies
Sam Langfield European Central Bank
Álvaro Leandro Peterson Institute for International Economics
Dietrich Matthes Quantic Risk Solutions
Pietro Reichlin LUISS Guido Carli University
Jörg Rocholl ESMT Berlin
Nicolas Véron Bruegel and Peterson Institute for International Economics
Jeromin Zettelmeyer Peterson Institute for International Economics
Sam Langfield agreed it is imperative to break the doom loop and to reinvigorate the process
with fresh ideas. The proposal by Dietrich Matthes and Jörg Rocholl included several nice features such as its simplicity, its use of the ECB capital key, and the recognition that there are genuine prudential reasons for banks to hold sovereign bonds. However, the proposal has limitations such as achieving only limited diversification, since sovereign bonds rated AA- or better retain a zero risk weight. If the framework had been in place in 2007, many banks would have held sovereign bonds that later turned out to be risky, without any incentive to diversify those holdings ex ante.
Sam Langfield also emphasised that the proposal would only achieve incomplete de-risking, as
the response of banks to the proposal depends on the elasticity to capital charges of their demand for sovereign bonds. Their risk profile may increase, as they may reallocate their portfolio from components subject to non-zero risk weight into other sovereign bonds, and in all likelihood buying the highest yielding and most risky sovereign bond conditional on receiving a 0% risk weight. In his view, reforms that induce banks to reduce their exposure to domestic risk, but increase that to foreign risk could therefore be counterproductive. This motivates the search for the ‘holy grail’ of a safe euro asset, which banks could use to both diversify and de- risk their sovereign bond portfolios.
In his response, Jörg Rocholl emphasised that the proposal follows the internal rating based (IRB) approach and thus does include risk charges even for bonds rated AA- or better. Dietrich
Matthes agreed that the risk may increase for low-risk banks diversifying their holdings.
However, the proposal includes a tolerance for excess holdings subject to an individual limit. The paper has not fully calibrated this, and those parameters could be adapted over time.
Jeromin Zettelmeyer agreed with the Sam Langfield’s comments but thought the argument of
banks is unlikely to serve as a good guide to whether a doom loop is in effect. Rather, the concern is with non-linear effects that are hard to gauge. Therefore, the proposal probably makes the system much safer despite not fully addressing the doom loop concern. Diversification should reduce overall risk. Nicolas Véron also wondered whether the median expected loss is a proper way to reflect systemic risk and recalled that home bias, not investment in public debt, is the salient European issue. Sam Langfield responded that in his view, even a state of partial diversification could increase the risk of contagion, hence incomplete diversification should remain a concern.
Jeromin Zettelmeyer also asked how the authors view the risk that the introduction of such a
scheme could trigger a crisis. Jörg Rocholl responded that Italy is the weakest link. However, there are three counterarguments. First, the share of Italy in the basket would also be large, so demand from other countries could be significant. Second, the buffer leaves some room for banks to retain some larger exposure to the sovereign bonds of their home countries. Third, the proposal would phase in over time, e.g. over seven to ten years. But a close look is warranted in order to avoid additional risk in the system. Dietrich Matthes added that the regulatory incentives of the proposal would make it attractive, for example, for Spanish banks to reinvest capital-free in other countries, such as Italy.
Pietro Reichlin asked why Spanish banks do not buy Italian bank obligations already. Dietrich
Matthes suggested one reason is the segmentation of primary markets. Nicolas Véron pointed
out recent work by Altavilla et al. (RoF, 2017), which presents a great literature review and empirical analysis of the origins of home bias. Jochen Andritzky added that it is far from clear how portfolio re-allocations induced by regulatory changes affect pricing, see for instance
Andritzky (2012).
Roel Beetsma pointed out that diversification has declined and market segmentation has increased since the start of the crisis. For the attractiveness of the proposal, it is important to understand the drivers behind this trend. If governments try to persuade local banks to buy their debt, any proposal limiting this may be politically unworkable. Jörg Rocholl argues that the regulation actually provides banks with incentives to withstand pressure from the government. Jochen Andritzky recalled the GCEE proposal putting an emphasis on hard exposure limits, given that without them you would not achieve the necessary diversification. With limited granularity in the euro area – a few large countries and highly correlated shocks – the benefit of diversification is limited. Nicolas Véron added that redenomination risk played a major role in the past crisis. In his view, a regime with smooth restructuring that can credibly reduce redenomination dangers would reduce overall risk.
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