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Europe’s banking union project, initiated in 2012, has had a promising start. But its stated aim of breaking the vicious circle between banks and sovereigns is very far from being achieved. A key bank-sovereign linkage is the euro area’s home-bias problem, namely the fact that the sovereign exposures of many euro-area banks are highly concentrated in the home country, instead of being diversified within the monetary union.

The home-bias problem, in turn, is a key obstacle to the adoption of a European Deposit Insurance Scheme (EDIS), as proposed by the European Commission in late 2015, because of the suspicion that deposits protected by EDIS would be used by banks, under moral suasion from their home country’s government, to excessively increase their purchases of that government’s debt. In turn, the absence of a full EDIS is one of the banking union’s greatest weaknesses because deposits are not protected uniformly.

There is therefore a strong policy case for the simultaneous consideration of EDIS and of a regulatory instrument targeted at reducing highly concentrated sovereign exposures. The adoption of one of these two reforms without the other is both unlikely and arguably undesirable.

To address the home-bias problem, a general and mandatory (Pillar 1) regulatory requirement is necessary. It should focus on sovereign concentration risk rather than sovereign credit risk, constraining only large exposures as opposed to the risk-weighting of all sovereign assets (the latter might also be envisaged, but on the condition of a global consensus and thus presumably at a later stage). Because the home-bias problem is unique to the euro area, the new requirement should only be binding for the euro-area sovereign exposures of euro-area banks.

This paper outlines a workable design for a Sovereign Concentration Charges Regulation (SCCR) as new EU legislation to be adopted as a complement of EDIS. The SCCR would add sovereign exposures above a certain threshold (defined as a ratio to Tier-1 capital), weighted by a coefficient (sovereign concentration charge) that increases with the exposure ratio, to risk-weighted assets in the capital ratio’s denominator. The charges for concentrated sovereign exposures to different euro-area countries would add up.

The proposed calibration for the SCCR errs on the side of leniency, to avert any risk of disturbance in sovereign debt markets. Sovereign exposures under 33 percent of Tier-1 capital would be entirely exempted. The marginal capital charges on concentrated exposures would be mild for exposures up to 100 percent of Tier-1 capital, and rise more steeply above that level. Should this calibration turn out to have an insufficient impact, it could be strengthened at a later stage.

The proposed transitional arrangements are also designed to ensure a smooth path towards the new regime even if market conditions become less favourable than currently. The transitional arrangements include extensive consultation with market participants, a gradual phase-in over a long period and grandfathering (i.e. exemption from the concentration charges) of all debt issued before the SCCR’s entry into force.

The SCCR does not require any consideration of a euro-area ‘safe asset’, but can easily accommodate a safe asset if it is introduced and incentivise its use if deemed appropriate.

While the banks’ behavioural response to the new regime is impossible to predict with certainty, it is expected that most banks will respond to the introduction of the SCCR by diversifying their sovereign exposures away from their current home bias, but leaving them largely unchanged in euro-area aggregate. If so, the reform will neither materially impact banks’ prudential ratios nor entail any material costs.

The adoption of the proposed SCCR together with a full EDIS, ideally complemented by other reforms to increase risk-sharing and enhance market discipline in the banking policy framework, would significantly reduce bank-sovereign linkages and thus strengthen the banking union, foster greater EU financial integration, and increase financial stability for each member state and for the European Union as a whole.