Resumen de Sovereign risk and financial stability
Christian Castro, Javier Mencía
The sovereign crisis in the Euro Area (EA) has prompted a debate about how sovereign debt should be treated in banking regulation. Against this background, we review the role of sovereign debt in advanced economies and its current regulatory treatment. We then assess the empirical support for two competing hypotheses explaining the evolution of banks� holdings of domestic sovereign debt during the recent crisis: i) macroeconomic factors; and ii) the commonly known �carry-trade hypothesis�. We find that macroeconomic conditions play a more relevant role than �carry-trade� incentives to explain the increase in banks� holdings of domestic sovereign debt in times of stress. Founded on this evidence and considering a set of distinctive characteristics of sovereign risk in the EA we assess different policy options. We argue that correcting fiscal imbalances and ensuring sound inter-temporal fiscal policy both at the country and EA level is a key precondition to financial stability and thus, a route to consider first. Addressing some of the sovereign risk manifestations is a second route. We identify three key building blocks to guide the design of possible regulatory measures on this area. We suggest that a macroprudential Pillar 2 approach would be the best suited to manage this special risk
