Infographic: Interaction between sovereigns and banks

The banking union has significantly reduced the risk that governments might have to bail out failing banks. Banks with large holdings of a sovereign’s debt still face risks when the sovereign is in financial stress. The Netherlands wants a discussion on how to address this risk. And will raise this issue at the informal meeting of the EU’s Economic and Financial Affairs Council (Ecofin) on 22 April 2016.

Risk of sovereign debt on bank balance sheets

Sovereigns issue debt to fund themselves. If a country finds itself in financial stress, the value of these bonds decreases. Some banks hold a relatively large quantity of sovereign debt from the country where they are based. This means they have a large exposure to the sovereign concerned.

During the sovereign debt crisis some banks even bought additional sovereign debt. This yielded more returns but also carried extra risks.

Regulatory treatment for sovereign debt

Under the current EU regulatory framework, banks often do not have to hold any equity for holding sovereign debt. Nor is there a limit on how many debt of one sovereign each bank may hold. This can pose a risk to the financial soundness of banks. EU legislation could aim to limit this risk. That is why the Netherlands has put this issue on the agenda of the informal Ecofin meeting.