No. 326 - Easier said than done? Reforming the prudential treatment of banks' sovereign exposures

In the aftermath of the euro-area sovereign debt crisis, several commentators have questioned the favourable treatment of banks’ sovereign exposures allowed by the current prudential rules. In this paper, we assess the overall desirability of reforming these rules. We conclude that the microeconomic and macroeconomic costs of a reform could be sizeable, while the benefits are uncertain. Furthermore, we highlight considerable implementation issues. Specifically, it is widely agreed that credit ratings of sovereigns issued by rating agencies present important drawbacks, but sound alternatives still need to be found; we argue that consideration could be given to the use of quantitative indicators of fiscal sustainability, similar to those provided by international bodies such as the IMF or the European Commission.