Author(s): Esa Jokivuolle and Matti Virén
Date published: Jul 2019
SUERF Policy Note, Issue No 87
by Esa Jokivuolle, Bank of Finland, and Matti Virén, Bank of Finland and University of Turku
JEL-codes: G21, G28.
Keywords: Banking union, banking integration, EMU development, loan portfolio diversification, bank capital requirements, IRBA.
We provide preliminary evidence of potential risk reduction benefits from banks’ loan portfolio diversification cross-border within the euro area. Using aggregate data on banking sector corporate loan losses for each euro area member-state, our estimates suggest that the static diversification benefit could be substantial. The minimum capital needed to withstand the maximum annual loss from a hypothetical fully diversified euro area bank loan portfolio over the period 2001-2017 would have been only 40 % of the total capital needed to withstand the maximum losses on a country by country basis. We also calibrate the country-specific loan loss distributions and the euro area portfolio’s loss distribution to the Vasicek (2002) model, which underlies the Basel framework’s Internal Ratings Based Approach. We find that the implied asset correlation parameter of a median country portfolio is about twice as large as that of the fully diversified euro area portfolio. These results suggest that there is substantial potential for risk reduction through further cross-border diversification in euro area loan portfolios. To encourage further banking integration, this potential might be recognized in bank capital requirements.
Read Full Text