Zero Risk Contagion - Banks' Sovereign Exposure and Sovereign Risk Spillovers

We investigate whether the application of risk weights impairs financial stability. Zero risk weight regulation associated with euro-denominated sovereign debt creates a “sovereign subsidy” for European banks, which amplifies the co-movement between sovereign credit default swap (CDS) spreads and a European sovereign CDS index. We do not find a similar co-movement with sovereign CDS spread changes of non-euro area sovereigns. More capital as well as less aggressive risk weighting mitigates this effect. Our results are robust to alternative hypotheses, and controlling for common shocks due to financial linkages among European countries, and the exposure of European banks to non-sovereign sectors.

Steffen, Sascha and Josef Korte (2015), Zero Risk Contagion - Banks' Sovereign Exposure and Sovereign Risk Spillovers,