Level 3 Assets and Sovereign Exposure
This chapter first revises the state of the art on Level 3 assets, one of the drivers of fragility for the euro area banking system. European authorities have mainly focused on fragility from credit risks, but the global financial crisis highlighted the importance of correctly pricing highly complex and opaque instruments. In this respect, the crisis started a trend towards simplification and transparency, entailing a radical change in banks’ business models. Then the chapter focuses on the linkage between sovereign debt and bank balance sheets. This chapter investigates two proposed options to address this issue: applying non-zero risk weights to sovereign exposures and putting limits on exposures to sovereigns, similar to those in place for other exposures.
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