By Francesco Guarascio
BRUSSELS (Reuters) - Euro zone banks should have limits set on their sovereign debt holdings, the head of the EU's new banking watchdog said on Tuesday, backing a proposed reform that could reduce banks' risk profiles but might affect bonds markets.
Most euro zone sovereign bonds are treated as risk free and are exempt from exposure limits imposed on banks' holdings of corporate or household debt.
European Union countries are debating whether to revise the favourable status enjoyed by public debt, which has lowered governments' borrowing costs while benefiting from an additional layer of protection under the European Central Bank's bond-buying programme.
But during the euro zone crisis it was held responsible for creating a "doom loop" of debt dependency between states and banks.
"There is no asset that is totally risk free," the head of the Single Resolution Board (SRB) Elke Koenig told EU lawmakers in the European Parliament in Brussels.
"Putting in place limitations on exposure to any single counterparty, including sovereigns, makes perfect sense," she added.
In January, the Dutch presidency of the EU set up a working group to discuss reducing banking risks, including changing the risk-free status of sovereign bonds.
Germany has linked an agreement on bank risk reduction to progress on a separate scheme to guarantee individuals' and firms' bank deposits up to 100,000 euros ($109,000), because it fears German depositors might be asked to bail out savers in poorer European states.
This proposed trade-off is seen as controversial in countries where banks have high sovereign debt exposure, such as Italy, because it may have a negative impact on bonds markets.
The Basel Committee on Banking Supervision is also discussing how to reduce banks' risks and set global standards on the treatment of sovereign bond holdings.
Koenig said that a European solution should be aligned to decisions made by the Basel Committee.
New rules introduced in January in all 28 EU countries envisage that banks' creditors -- including shareholders, bondholders and large depositors -- should incur losses before a lender can be rescued.
In a concession to countries where partial application of those new 'bail-in' rules led to widespread protests and in one case the suicide of a pensioner in Italy, Koenig said investors who have lost fortunes should be supported "out of social considerations".
($1 = 0.9200 euros)
(Reporting by Francesco Guarascio; editing by Philip Blenkinsop and John Stonestreet)