BRUSSELS: The European Commission plans to review rules on banks' holdings of sovereign bonds to break excessive exposures to national debt, seen as a vulnerability of the euro zone banking system, a document released on Tuesday said.
Most sovereign bonds are currently exempt from "large exposures" limits which are instead imposed on banks for their holdings of corporate or household debt.
This has allowed governments to reduce yields on their bonds and get cheaper funding, but was blamed during the euro zone debt crisis for creating a "doom loop" between states and banks. That means the worsening of public finances has a disproportionate impact on a state's financial system, and troubled banks affect their countries' financial standing.
The European Commission, the EU executive, wants to break that link and plans proposals "to ensure that banks' exposures to individual sovereigns' risk is sufficiently diversified," said the document accompanying a legislative proposal to set up a European deposit guarantee scheme.
The plan follows announcements made by the leaders of the EU institutions in June in a joint report on the future of the monetary union.
"In the medium term, it may make sense to review the treatment of bank exposures to sovereign debt, for example by setting large exposure limits," the report said. The head of euro zone finance ministers Jeroen Dijsselbloem and the president of the European Commission Jean-Claude Juncker were among the authors of the report.
In a document published in March, the European Systemic Risk Board, chaired by the European Central Bank President Mario Draghi, also advised to "disincentivise outsized investments in sovereign risk," with measures such as the introduction of ceilings for large exposures.
"The adequacy of the prudential treatment of banks' exposures to sovereign risk should be re-considered," the Commission said on Tuesday, announcing future "necessary proposals" that will take into account financial stability.
Among the largest euro zone countries, Italy and Spain would be likely to see the biggest impact on their bond markets, as banks in those countries hold significant amounts of their sovereign debt.
A debate is continuing within the European Central Bank on whether a quantitative cap should be preferred to a limit based on the asset risk.
The ECB's chief supervisor Daniele Nouy favours a 25 percent cap, and is supported by the head of Germany's Bundesbank Jens Weidmann, while ECB Vice President Vitor Constancio backs instead a risk-weight approach.
A 25 percent cap on large exposures to sovereigns -- the same as that applied to other debt -- would force euro zone banks to sell bonds worth 1.1 trillion euros, according to a report by credit rating agency Fitch published last year.
"There is no better moment to set limits to large sovereign exposures," Guntram Wolff, director of Brussels-based think tank Bruegel, told Reuters. He argues that banks can more easily now offload some of their excessive bonds onto the ECB and in turn help its bond-buying stimulus programme, while increasing the financial stability of the euro zone.
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