An intensely debated topic in the context of possible further financial reforms, in Europe and internationally, concerns possible actions to address the negative loop between sovereign risk and bank risk. The sovereign-bank nexus was one of the main amplifying factors of financial distress during the euro area crisis. Banks’ difficulties affected sovereigns directly, through the bailout of troubled intermediaries, and indirectly, through the impact of the disruption of lending on the economy. Sovereigns’ difficulties affected banks’ ratings, funding costs, and balance sheets, while the recession worsened their lending portfolios.
Before the euro-area sovereign debt crisis, sovereign defaults were regarded as a problem of emerging economies. Indeed, no advanced (OECD) country defaulted on its domestic debt between 1950 and 2010.1 Therefore, it is not surprising that virtually all national supervisory authorities have exercised the regulatory option to exempt banks’ exposures to their domestic sovereign, denominated and funded in domestic currency, from the standard prudential banking regulation. These exposures are de facto subject to no concentration limits and to a zero risk weight regime.[...]