What a difference a decade makes. The Eurozone sovereign debt crisis of 2010‑12 saw sovereign bond spreads between several member states and Germany widen sharply.

Subsequent reforms and current favourable growth expectations have since compressed those spreads back to near record lows. The calm, however, may not last. A dip in growth expectations or a revival of fiscal doubts could send risk premiums soaring once again. With public debt and interest bills in many countries climbing rapidly, such a reversal is anything but remote – and it highlights persistent structural risks to the euro area’s financial stability.

Many Eurozone banks hold outsized amounts of their own governments’ bonds, a structure that can turn fiscal trouble into banking strife as the debt loses value. In a worst-case scenario, governments would be forced to support the recapitalisation of banks in distress, in turn worsening their fiscal situation and probably leading to a sell-off in their bonds: the so-called sovereign-bank nexus.

Furthermore, when a government’s finances sour, mark-to-market losses erode bank capital and may prompt banks to curb lending, which could damp growth and intensify budget pressures. Because banks across the currency union are closely interconnected, such strains can quickly spill across borders and endanger financial stability. Breaking this cycle is essential for safeguarding the stability of the Eurozone financial system.

Sovereign bonds are inherently attractive to banks: they trade in deep, liquid markets and deliver a steady coupon backed by the taxing power of the state. Regulation amplifies that allure by classifying the paper as near risk-free – exempt from risk-based capital requirements and large-exposure limits.

So, the most attractive place for a bank to park money is often its home country’s sovereign debt. As a result, some institutions now carry domestic sovereign holdings worth several times their capital, leaving their balance sheets dangerously exposed to home-country risk.

Global standard-setters are well aware of this danger. The Basel Committee on Banking Supervision has spent years debating risk weights and caps for sovereign exposures, yet a comprehensive accord remains elusive. That cannot be the Eurozone’s excuse for inaction. Its unique architecture – one money but 21 treasuries – calls for sound fiscal positions and decisive steps to sever the sovereign-bank nexus. Curtailing excessive home bias is essential for any further step towards completing the EU’s banking union plans, including a deposit insurance scheme.

The cleanest fix would be scrapping the regulatory privileges on government debt exposures. This debt should be subject to the same rules that govern other assets such as loans to non-public borrowers: risk-weighted capital charges and fixed caps on single-borrower exposures, depending upon a bank’s own capital.

Banks would have to hold more capital against exposures to highly indebted nations, and positions above a set share of their own capital would be capped. So far, however, such reforms have foundered. Those benefiting from the status quo resist change. Market participants warn of volatility and governments fear higher financing costs, particularly in fiscally weaker member states.

An alternative approach could be the introduction of “concentration surcharges”, instead of strict exposure limits. Under this approach, additional capital requirements would only apply to sovereign exposures exceeding a certain threshold. This would preserve preferential treatment up to a point and discourage excessive single-sovereign exposures beyond it. The home bias of the asset side of the banks’ balance sheets would be reduced.

Concentration surcharges would also set additional incentives for governments to avoid excessive public indebtedness, in particular, when they would increase with sovereign debt and deficit ratios. Such a compromise could strike a balance between mitigating systemic risk and addressing political concerns.

Any reform must carefully balance multiple objectives. Measures should aim to reduce excessive concentration in sovereign exposures while preserving the critical role of banks in maintaining market liquidity. Sovereign bond markets are also essential for supporting the effective transmission of monetary policy.

These functions must remain intact. Given the critical role of banks in maintaining market liquidity, a phased implementation would be needed to give them sufficient time to adjust their portfolios, minimising potential market disruptions.

A timely agreement on a phased and more risk-related regime for the banks’ sovereign exposures would be an important milestone on the road to a more resilient European financial system and could help lay the groundwork for completing the banking union. Such a framework would strengthen the euro area’s ability to absorb future shocks and reinforce confidence in the single currency. Acting now would create a lasting dividend of resilience, competitiveness and sustainable growth for Europe.