How Europe Could Quietly Raise America’s Borrowing Costs Through Its Own Banking Rules

The asymmetry has been hiding in plain sight for years. European investors—insurers, banks, pension funds, and others—hold roughly $9.6 trillion in U.S. assets. American investors hold about $6.4 trillion in European assets. That 1.5-to-1 gap represents structural financial leverage that existing European prudential rules could activate without new treaties, capital controls, or coordinated government sales.

A new report from the Kiel Institute for the World Economy, released this month, makes the mechanism concrete. Filippos Petroulakis of the Bank of Greece and Farzad Saidi of the University of Bonn and Kiel Institute argue that simply removing the zero risk-weight and zero spread-risk privilege currently granted to U.S. Treasuries under the EU’s Solvency II insurance rules and the Capital Requirements Regulation (CRR) for banks would raise the capital cost of holding those securities. The result, they estimate, would be a cumulative $200 billion reduction in European demand for U.S. Treasuries over a decade—roughly one-quarter the scale of the Federal Reserve’s first quantitative tightening episode or one-third of QE2 in its long-bond component.

That is not a fire sale. It is a slow, rules-driven portfolio reallocation. But because Treasury markets are forward-looking, the announcement effect alone would reprice the expected path of future demand. Conservative modeling suggests a 11-14 basis point increase in yields, translating into $33-42 billion per year in additional U.S. debt-service costs at current debt levels—comparable to one-fifth to one-quarter of the U.S. Department of the Army’s annual budget.

The Regulatory Subsidy That No Longer Fits the Facts

Under current rules, U.S. Treasuries receive exceptionally favorable treatment in Europe. For insurers under Solvency II, they carry a zero spread-risk charge regardless of rating or duration. For banks under the CRR standardized approach, exposures to non-EEA OECD central governments in the issuer’s own currency attract a zero risk weight. The original rationale—OECD sovereigns are “risk-free”—has eroded. U.S. federal debt held by the public now exceeds 100 percent of GDP and total public debt stands around 122-124 percent of GDP in recent quarters, with the trajectory still upward. Major rating agencies have already moved away from AAA.

The authors benchmark an alternative treatment on A-rated sovereign risk. For insurers, assuming an average modified duration of seven years (consistent with both the Treasury market’s average maturity and institutional preferences), this produces an 8.4 percent spread-risk stress factor. For banks, a 20 percent risk weight applies—the level assigned to A+/A– sovereigns under Basel standards.

These are not trivial charges. They create a durable incentive to reduce exposure.

Quantifying the Flow: Insurers, Banks, and Pensions

The report draws on U.S. insurance literature—particularly Becker, Opp, and Saidi (2022) on the 2009 NAIC reform that eliminated capital requirements for certain mortgage-backed securities—to estimate selling elasticities. Every one-percentage-point increase in risk-based capital charges raises the annual probability that an insurer will sell some portion of the position by roughly 0.7 percentage points. Applying conservative assumptions (50 percent of holdings sold conditional on a decision to sell), the authors derive an annual selling rate of about 0.35 percent of holdings per percentage-point capital increase.

Applied to the 8.4 percentage-point charge for insurers, this implies roughly 2.9 percent of holdings sold per year, or 29 percent cumulatively over ten years. Using conservative holdings data—approximately $100 billion for EEA insurers and $65 billion for UK insurers—the direct impact is around $48 billion over the decade.

Banks respond differently but powerfully. Evidence from the 2011 EBA capital exercise (Gropp et al., 2019) shows that banks primarily adjust via asset-side reductions in risk-weighted assets rather than equity issuance. A 20 percent risk weight on previously zero-weighted Treasuries would increase RWA by 20 percent of the position. If banks can substitute into zero-risk-weight European sovereigns, the upper bound is full divestment; realistic frictions suggest a large but partial adjustment. Euro-area banks hold at least $350 billion in U.S. Treasuries and agencies on banking books; a conservative UK figure adds another $300 billion. The modeled impact: up to $130 billion in potential sales.

Pension funds, less directly constrained by asset-specific capital charges, are treated more conservatively. Even assuming only one-third the selling rate of insurers, they add another $24 billion. The aggregate demand shock: on the order of $200 billion over ten years.

These figures are deliberately cautious. They exclude broader institutional investors and assume linear responses rather than threshold effects. They also predate any second-round market-price adjustments that could amplify or dampen flows.

Transmission Channels: Yields, FX, and a Self-Reinforcing Loop

Higher capital charges do not operate in isolation. Two features make the policy self-reinforcing.

First, the reallocation of insurer capital toward European sovereign and bank bonds improves the funding profile of European banks. EIOPA data already show insurers holding €500-600 billion in European bank bonds. Shifting even a fraction of the redirected flows into long-term bank debt represents a material expansion of the investor base for euro-area bank term funding. This reduces European banks’ structural reliance on dollar wholesale markets—the very constraint that might otherwise deter them from reducing their own Treasury holdings.

Second, hedging dampens the immediate market impact. Drawing on Du and Huber (2024) and updated national data, European investors hedge a substantial share of their dollar bond exposures—often near 100 percent for insurers and pensions on the fixed-income side, though lower on equities and varying sharply by country (Denmark and Sweden near the high end; broader euro-area active investors around 33 percent). When a hedged Treasury position is sold, the simultaneous unwind of the short-dollar forward reduces pressure on the spot exchange rate. The net effect is a more gradual dollar depreciation and yield adjustment than an unhedged fire sale would produce. Replacement demand from yield-seeking investors (Asian central banks, global pensions, domestic U.S. buyers) provides a further buffer, though it does not restore the structurally captive European institutional bid that the regulatory change removes.

Benchmarking against QT1 (Eren, Schrimpf, and Xia, 2026) and granular Treasury demand models (Jansen, Li, and Schmid, 2025) produces the 11-14 basis point yield estimate. Because markets price the expected path of demand on announcement, the bulk of the adjustment can occur before the full decade of flows materializes.

Realism, Risks, and Counterarguments

Skeptics rightly note political and operational hurdles. Coordinated recalibration of Solvency II and CRR would require alignment across EU institutions and, ideally, the UK. Markets could react negatively to perceived weaponization of prudential rules. Replacement buyers exist. And Europe’s own banks remain exposed to dollar liquidity risk in stress.

Yet the report’s framing is narrower and more defensible than the dramatic “nuclear option” narratives that occasionally circulate on social media. This is not a sudden coordinated dump of trillions. It is a recalibration of capital rules that have become increasingly difficult to justify on pure prudential grounds. Du, Keerati, and Schreger (2026) document a clear decoupling: the dollar’s convenience yield remains robust, but the convenience yield on Treasuries themselves has turned negative at medium-to-longer maturities as relative supply has grown. Subsidizing an asset whose scarcity premium has eroded is poor regulatory design.

Recent precedent is telling. When a single mid-sized Danish pension fund sold roughly $100 million in Treasuries in response to U.S. statements on Greenland, the U.S. Treasury Secretary addressed the decision publicly at Davos. Scale that signal across the European institutional complex and the market and political salience rises sharply.

Strategic Implications

For Washington, the analysis underscores that dollar dominance and the Treasury market’s depth are not unconditional. They rest partly on the willingness of large, rules-constrained foreign investors to treat U.S. government debt as uniquely privileged. Altering that treatment changes the equilibrium.

For Europe, the mechanism offers a form of leverage that does not require new institutions or treaty change. It operates through the same prudential architecture that already shapes hundreds of billions in cross-border holdings. The self-reinforcing channel—stronger demand for European bank bonds reducing dollar funding dependence—further lowers the cost of using the tool if circumstances ever warranted it.

The deeper point is not that Europe will imminently pull this lever. It is that the asymmetry exists, the regulatory instrument is already in European hands, and the zero-risk-weight treatment of U.S. Treasuries has lost its original macroprudential justification. In an era of heightened geopolitical and fiscal uncertainty, that combination deserves serious analytical attention rather than dismissal as theoretical.

Markets price permanence. A credible, rules-based shift in the composition of structurally reliable buyers would not need to be large in annual flow terms to move yields and expectations durably. The Kiel analysis suggests the scale could be material—tens of billions per year in extra U.S. borrowing costs—while remaining within the bounds of ordinary prudential recalibration.

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References

Becker, B., Opp, M. M., & Saidi, F. (2022). Regulatory forbearance in the U.S. insurance industry: The effects of removing capital requirements for an asset class. Review of Financial Studies, 35(12), 5438–5482. https://doi.org/10.1093/rfs/hhac045

Du, W., & Huber, A. W. (2024). Dollar asset holdings and hedging around the globe (NBER Working Paper No. 32453). National Bureau of Economic Research.

Du, W., Keerati, R., & Schreger, J. (2026). Decoupling dollar and Treasury privilege (NBER Working Paper No. 35000). National Bureau of Economic Research.

Eren, E., Schrimpf, A., & Xia, F. D. (2026). The demand for government debt. Management Science. Advance online publication.

Gropp, R., et al. (2019). Banks’ response to higher capital requirements: Evidence from a quasi-natural experiment. Review of Financial Studies, 32(1), 266–299.

Jansen, K. A. E., Li, W., & Schmid, L. (2025). Granular Treasury demand with arbitrageurs [Working paper]. University of Southern California.

Petroulakis, F., & Saidi, F. (2026). Shorting America: Europe’s financial leverage over the United States (Kiel Report No. 7). Kiel Institute for the World Economy. https://www.kielinstitut.de/publications/shorting-america-europes-financial-leverage-over-the-united-states-19899/

U.S. Department of the Treasury. (2026). Treasury International Capital (TIC) data [Data sets]. https://home.treasury.gov/data/treasury-international-capital-tic-system