The EU sovereign debt crisis: potential effects on EU banking systems and policy options

This paper aims at investigating some of the critical issues highlighted by the sovereign debt crisis in European Union (EU) Member States (MS). The goal is twofold: 1) Quantify the increase in the risks of the EU banking systems due to haircuts of sovereign debts of some EU Member States, which have been particularly touched by the sovereign crisis; 2) evaluate and compare the policy options which have been adopted to address the issue. The first goal is achieved by estimating the increase in the banks Probability to Default (PD), due to the haircuts in sovereingn debts, through a further development of the SYMBOL model to estimate the PDs by numerical inversion of the Basel FIRB formula for minimum capital requirements. For the second objective the measures within the Basel III Accord, which among the others increases the quality and quantity of capital that banks should set aside to cover from unexpected losses, are compared with the agreement on bank recapitalisation and funding reached by the European Council in October 2011, which responded to the urgent consequences of the sovereign bonds crisis in the EU. The analysis is performed on the 65 large EU banking groups identified by the European Banking Authority (EBA) for the capitalisation exercise.. Results show that the haircuts on sovereign debts of EU MS in crisis would heavily worsen the stability of their banking systems but could also sometimes affect financial stability of other EU countries. We also show that the creation of a temporary capital buffer in the form of a capital target, necessitated by the exceptional circumstances prevailing in some EU MS, represent a step forward to Basel III rules.