LONDON SCHOOL OF ECONOMICS

This paper examines the vulnerability of banks in EMU countries to shocks to default risk premiums on public debt. This vulnerability depends on (1) the total amount of public debt in bank portfolios, (2) the extent to which the default risk of public debt of EMU member states is diversifiable, and (3) the degree of actual geographical diversification of public debt holdings by banks. We simulate the effect of country-specific default shocks on the market value of public debt held by banks. The simulations are based on data of public debt positions at the aggregate banking sector level and take into account the historical covariance structure of default risk premiums in the EMU. We compare two scenarios. First, we calculate the effect on the standard deviation of the equity-to-assets ratio if banks continue to hold mainly domestic public debt. Next, we calculate this effect if banks diversify their investments in public debt across EMU governments. We find that the standard deviation of the equity-to-assets ratio declines considerably if banks diversify their public debt holdings and conclude that the risks of bank failures caused by default on public debt can be reduced through proper geographical diversification. We close with some implications for prudential regulation. JEL Classification: H6, G18, G28.

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