How Much Economic Capital Could European Banks Save? The Case for Optimal Sovereign Risk Allocation

Carlo Capuano and Luigi Ruggerone

In response to the global financial crisis, banks have become increasingly aware of the scarcity and cost of capital, and of the difficulties of granting an adequate remuneration to it,¹¹On this, see Chapter 1 of IMF (2014). and have started to implement extensive projects aimed at optimising its utilisation. These processes are often very complex, as banks’ capital is subject to various regulatory and accountancy constraints that must be complied with – and which are, at times, silent about some aspects of commercial banks operations.

When it comes to optimising the allocation of sovereign risk exposure, it can be more useful to examine the concept of economic capital rather than that of regulatory capital.²²The Basel Committee on Banking Supervision recognises that: “Several banks note the use of economic capital as another complementary view of a bank’s condition” (BIS, 2014a, p 4). There are several big multinational banks where exposures to sovereign risk have contributed extensively to generated revenues and overall risk exposure. However, sovereign risk is one of those areas where regulatory bodies appear to be less sharp (or more complacent) in driving banks’ regulatory