European banks and sovereigns in the euro area; may reduce concentration risk

European banks and sovereigns in the euro area; may reduce concentration risk

Fiscal risks and financial stability: reform options for the sovereign-bank nexus in the euro areaMonthly Report – September 2026

DE Monatsbericht – September 2026 EN Monthly Report – September 2026

Fiscal risks and financial stability: reform options for the sovereign-bank nexus in the euro area

2 The sovereign bank nexus in the euro area: a challenge for financial stability

Supplementary information: Debt of regional governments and local authorities as part of general government debt

3 Risks arising from high concentrations of sovereign exposures

Supplementary information: Stress test methodology to analyse the risks for banks arising from high portfolio concentration in sovereign debt instruments

4 Regulatory treatment of sovereign exposures

5 Reform options: sovereign concentration charges and concentration limits

The sovereign-bank nexus remains a key source of financial stability risk in the euro area. It is the term used to refer to the interconnectedness between sovereigns and banks: when a sovereign’s creditworthiness deteriorates, rising risk premia on its bonds can put pressure on banks holding large amounts of that debt. Conversely, bank distress can put pressure on public finances if government support is expected or becomes necessary. While the European resolution regime and banks’ strengthened capital positions have reduced the risk of bank crises damaging public finances, banks remain vulnerable to fiscal risk.

Many banks in the euro area hold a large share of their sovereign exposures to their home sovereign. This preference, known as “home bias”, amplifies the sovereign-bank nexus. The preferential regulatory treatment of sovereign exposures encourages high portfolio concentrations and can promote home bias. As a result, banks avoid large sovereign exposures to individual countries.

A model-based stress test analysis shows that banks with large holdings of sovereign bonds are disproportionately affected. In the simulations, the Common Equity Tier 1 ( CET1 ) capital ratio declines most sharply for institutions with large holdings of domestic sovereign bonds. By contrast, the declines are smaller where portfolios are more diversified.

Given the European monetary union’s distinctive institutional architecture – a single monetary policy combined with fiscal policies that remain largely national – there is a strong case for European reforms aimed at weakening the sovereign-bank nexus. This article discusses sovereign concentration charges and limits as instruments for curbing high concentrations of sovereign exposures. Sovereign concentration charges would trigger capital requirements for large exposures to individual countries. Concentration limits would directly cap such exposures. Both approaches could incentivise greater diversification of sovereign exposures.

Potential adverse side effects could be mitigated through careful calibration, a phased introduction and appropriate transition periods. In addition to strengthening financial stability, the regulatory treatment of the sovereign-bank nexus should also support further progress towards a European banking union.

The global financial crisis of 2008 and the subsequent European sovereign debt crisis showed that links between banks and sovereigns can put financial stability at risk. In the euro area, doubts about a sovereign’s debt sustainability led to problems in the banking sector, which, in turn, affected the stability of public finances in the wake of government bailouts. At the same time, the banking crisis put pressure on public finances, particularly where government support measures became necessary. In several member countries, bank and sovereign debt problems were thus mutually reinforcing. 1

The close interdependence between banks and sovereigns, known as the sovereign-bank nexus, remains an important source of systemic risk to the financial system. 2 Banks’ exposures to individual sovereigns remain high in the euro area and often exceed their capital. High concentrations of a single sovereign’s debt 3 increase banks’ dependence on that sovereign’s creditworthiness. This is because a deterioration in credit quality or changes in the general interest rate environment can lead to considerable losses in the value of sovereign debt. Depending on how these losses are treated for accounting and regulatory purposes, they can place considerable strain on banks’ balance sheets. This vulnerability may become more significant as hedge funds and other financial market investor groups have been growing increasingly active in sovereign bond markets for some time now. These investors often pursue short-term strategies that have procyclical effects during periods of stress and can thus amplify price swings in sovereign bond markets. 4 At the same time, there are other transmission channels that can magnify risks within the financial system and propagate them across borders. These include, in particular, credit linkages, funding markets and confidence effects.

The sovereign-bank nexus can trigger a self-perpetuating spiral. Doubts about a sovereign’s debt sustainability weaken banks that hold large amounts of that sovereign’s debt. If the government considers it necessary to support these banks, the resulting bailouts put pressure on public finances. This, in turn, can cause misgivings about the sovereign’s debt sustainability to multiply. The mere expectation of government support may lead to a loss in confidence in financial markets and higher government borrowing costs. As a result, the spiral of interdependence between banks and sovereigns may intensify: further losses in the value of sovereign debt would place additional strain on the banking sector. Banks may therefore feel compelled to curb their lending. This, in turn, can dampen economic activity and put even greater pressure on public finances.

Reforms in the euro area have reduced sovereigns’ vulnerability to bank distress, but banks nevertheless remain exposed to fiscal risk. This fiscal vulnerability to bank distress has been reduced, in particular, by the European bank resolution regime. In addition, banks’ significantly strengthened capital base since the euro crisis has increased their resilience. The European resolution regime requires private creditors and shareholders to share in losses. At the same time, banks remain vulnerable when sovereign fiscal risks spill over into the banking sector. Sound fiscal policies in the member countries can significantly limit these risks. They enhance sovereign debt sustainability and thereby reduce the likelihood of defaults on sovereign debt. This makes strict compliance with European fiscal rules crucial to maintaining sustainable government finances. The issue is particularly important because, given banks’ portfolio structures, fiscal risks feed back especially strongly into national banking systems.

Banks frequently hold highly concentrated portfolios of domestic sovereign debt. This preference for domestic sovereign debt is referred to as “home bias”. It can be explained by factors such as lower information costs, greater familiarity with the legal, political and administrative framework of the home country, and political influence. 5 Home bias is a key channel through which the risk interdependence inherent in the sovereign-bank nexus becomes entrenched. It increases banks’ balance sheet dependence on the creditworthiness of their domestic sovereign. While banks’ demand for their home country’s sovereign debt can help support government financing even in periods of market stress, this stabilising function comes at the cost of greater interdependence: the country concerned remains reliant on its domestic banking sector as a buyer of its debt. At the same time, banks, for their part, become more dependent on sovereign creditworthiness. 6 However, home bias is not attributable solely to information advantages or political factors. The regulatory framework, too, plays a role in its formation.

The preferential regulatory treatment of sovereign exposures can promote home bias and concentration risks on banks’ balance sheets, thereby amplifying the sovereign-bank nexus. Under the European Capital Requirements Regulation ( CRR ), exposures to governments of member countries that are denominated in the national currency of that country are assigned a risk weight of 0 %. 7 Additionally, these exposures are exempt from the large exposure limit requirements. 8 Sovereign debt therefore receives preferential regulatory treatment over exposures to private borrowers, whose credit and concentration risks are generally captured within the regulatory framework. By granting preferential treatment to sovereign debt, the regulatory framework provides banks with little incentive to avoid building up substantial exposures to individual sovereigns. The rules currently in force thus contribute to concentrated holdings of sovereign debt and to the entrenchment of the sovereign-bank nexus. 9

The particular architecture of the European monetary union amplifies the risks arising from the sovereign-bank nexus. Despite the coordination mechanisms in place, the euro area countries retain broad decision-making autonomy over economic and fiscal policy. At the same time, the Eurosystem, which is responsible for monetary policy, was granted extensive independence and assigned a clear mandate focused primarily on maintaining price stability across the euro area. The Eurosystem determines the need for action on the basis of conditions across the euro area as a whole. Adverse developments in individual euro area countries therefore carry less weight. Accordingly, in the event of a crisis affecting a single member country, the monetary policy response can be expected to be more limited or less forceful. Despite the considerable progress made in banking regulation, the risks arising from the sovereign-bank nexus thus remain a key challenge for the euro area, even more than a decade after the European sovereign debt crisis. In light of these considerations, there is a strong case for targeted regulatory adjustments in the monetary union to counter the financial stability risks arising from the sovereign-bank nexus. 10

Regulatory reforms aimed at limiting the sovereign-bank nexus should not unduly impair the key functions that sovereign bonds perform in financial markets. Sovereign debt instruments are not only an important source of government financing; they are also a key element underpinning the stability and effective functioning of financial markets. For example, they serve as benchmarks for valuing a wide range of other asset classes and are highly significant for market liquidity, collateral transactions and monetary policy transmission. Regulatory interventions should therefore carefully balance their intended effects against the risk of excessively restricting these functions. A phased introduction would allow the necessary adjustments to be made over a longer period, thereby minimising the risk of market turmoil and significant adverse effects.

Proposals to reduce the preferential regulatory treatment of sovereign debt have already been put forward in the past. The Basel Committee on Banking Supervision has extensively examined the possibility of aligning the regulatory treatment of exposures to sovereign issuers with that of exposures to private borrowers and has discussed various reform options. 11 However, no consensus emerged in favour of a fundamental adjustment of the regulatory framework to achieve such alignment. The ending of preferential treatment for sovereign debt is therefore not likely to be politically deliverable on the global stage.

Sovereign concentration charges and concentration limits could be used to specifically curb excessive exposures to individual sovereigns on banks’ balance sheets. Both approaches aim to reduce the concentration risks associated