Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/299238 
Year of Publication: 
2024
Series/Report no.: 
Deutsche Bundesbank Discussion Paper No. 16/2024
Publisher: 
Deutsche Bundesbank, Frankfurt a. M.
Abstract: 
Financial institutions, especially in Europe, hold a disproportionate amount of domestic sovereign debt. We examine the extent to which this home bias leads to capital misallocation in a real business cycle model with imperfect information and fiscal stress. We assume banks can hold sovereign debt according to a zero-risk weight policy and contrast this scenario to one in which banks weight the sovereign debt according to default probabilities. Banks are assumed to miscalculate the probability of a disaster state due to moral hazard and imperfect monitoring. This distortion pushes the economy away from the first-best allocation. We show that the zero risk weight policy exacerbates these distortions while a non-zero risk-weight improves allocations. The welfare costs associated with zero-risk weight policies are large. Households are willing to give up 3.2 percent of their consumption to move to the first-best allocation, whereas in the economy with non-zero risk-weights households are willing to give up only 1.2 percent of their consumption to move to the first-best allocation.
Subjects: 
Zero-Risk Weight
Fiscal Limit
Macroprudential Regulation
Sovereign-Bank Nexus
Fiscal Stress
JEL: 
E61
E62
ISBN: 
978-3-95729-991-8
Document Type: 
Working Paper

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