The European policy issue:

The new regulatory framework introduced following the crisis has imposed higher capital requirements and tougher rules for the recognition of loan losses making banks safer, and governments less exposed to the banking sector. However, the problem of contagion going in the other direction, from sovereigns to banks has not been solved. On the contrary, since regulation has pushed banks to hold a larger amount of “safe” treasuries o their portfolios, the potential risk has increased.

The home bias in the portfolio of banks has become a contentious issues and one of most difficult to solve in order to achieve an integrated banking system in the euro area, where risks are properly diversified and contagion problems are not ubiquitous. All the countries that oppose a mutualization of sovereign risk are slowing the introduction of a universal common deposit insurance scheme because domestic sovereign risks in banks’ portfolios are still very large. However, getting out of this conundrum is problematic, because the assumption that sovereign debt is riskless is a cornerstone of bank capital regulation. And larger capital requirements have increased sovereign risks in banks’ portfolios. The only way out is a requirement for banks to hold a diversified portfolio of securities, but this would involve a Copernican revolution in the relationship between sovereigns and financial intermediaries. Sovereigns would need to give up the power to force financial intermediaries to back sovereign debt, by either fiscal incentives or regulatory measures.

We aim to increase our understanding of these problems by applying the gravity models developed to study the home bias to analyze data from financial intermediaries.