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Breaking the doom loop: The euro zone basket

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The authors develop a suggestion of how to break the sovereign-bank nexus which does not involve pooling and/or tranching. At the same time, it does not require capital provision for sovereign portfolios held as collateral for liquidity operations with the lender of last resort (LOLR). According to the authors, it differentiates between the purpose of collateral for LOLR liquidity operations and the individual investment decision of which sovereign debt to hold. In this way, the methodology is market-driven and can foster financial integration in Europe, they say.

ESMT White Paper No. WP-17-01
October 2017
Source:  ESMT Berlin

Authors:
Dietrich Matthes, Quantic Risk Solutions
Jörg Rocholl, ESMT Berlin

Breaking the Doom Loop: The Euro Zone Basket

Abstract:

The paper develops a new suggestion on how to break the sovereign-bank nexus. This nexus, which is due to significant holdings of domestic sovereign debt by Euro zone banks, endangers financial stability. Our suggestion does not involve pooling and/or tranching and is fully consistent with standard Basel capital requirements. At the same time, it does not require capital provision for sovereign portfolios held as collateral for liquidity operations with the lender of last resort (LOLR). Rather, it differentiates between the purpose of collateral for LOLR liquidity operations and the individual investment decision of which sovereign debt to hold. In this way, our methodology is market-driven and can foster financial integration in Europe.

Executive summary:

Euro zone banks have significant holdings of domestic sovereign debt, inducing a close sovereign-bank nexus that endangers financial stability. We present a suggestion of how to break this nexus, which does not involve pooling and/or tranching and is fully consistent with standard Basel capital requirements. At the same time, it does not require capital provision for sovereign portfolios held as collateral for liquidity operations with the lender of last resort (LOLR). Rather, it differentiates between the purpose of collateral for LOLR liquidity operations and the individual investment decision of which sovereign debt to hold. In this way, our methodology is market-driven and can foster financial integration in Europe.

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