15 November 2019

European Commission: The sovereign-bank nexus in the euro area: financial and real channels

This paper reviews the direct (financial) channels and the indirect (real) channels through which banks and sovereigns interact, and that can give rise to feedback loops between the two sectors. While significant progress has been achieved in mitigating the direct channel of the loop in recent years, the indirect mechanisms of the loop stayed largely intact.

This paper reviewed the sovereign-bank nexus in the euro area, also in light of its past crisis experience. Some salient empirical observations from this period include

the fact that past government-sponsored financial sector interventions put strong pressure on the public finances of several euro area Member States in the form of actual and contingent liabilities;

evidence of a clear home bias in banks’ sovereign debt holdings, which furthermore tended to increase during the crisis; and

the fact that the euro area crisis saw hikes in government risk premia correlate with similar hikes in the domestic corporate sector, both financial and non-financial.

From a theoretical viewpoint, the interactions between banks and sovereigns can be understood as taking place via direct and indirect channels. The former relates to banks’ holdings of domestic sovereign debt and to the possibility of public interventions to bail out, or otherwise safeguard, the financial sector, carrying fiscal implications for the sovereign. The indirect channel captures real economy dynamics, including the fact that

credit constraints and restrictive fiscal policies can mutually reinforce each other and

private sector funding costs can experience contagion from rises in sovereign funding costs.

A review of the literature and analysis using the Commission’s SYMBOL and QUEST models shows how adverse loops may emerge along either dimension.

Taking stock of the advances in mitigating the sovereign-bank loop, it can be concluded that significant progress has been achieved as regards the direct channel. While government debt levels have increased compared with the pre-crisis period, the banking sector is more strongly capitalised and the institutional framework of the euro area underwent important improvements. Chief among these are a single supervisory mechanism and a new resolution framework, including the creditor bail-in tool and a fledging single resolution fund. Simulations using the SYMBOL model show a marked reduction in risks to the government sector originating from a banking crisis when comparing the current situation with the crisis year of 2012. An impressive reduction is observed, in particular, when one considers the use of the bail-in tool and of a single resolution fund, which suggests that policy action taken since the crisis has helped to reduce potential losses to a small fraction of those previously possible.

While the new institutional framework carries much actual and potential benefits, it is still missing a European deposit insurance scheme that could further weaken the direct channel between banks and sovereigns. Other policy options include regulatory action to decrease concentration and other risks in banks’ sovereign debt portfolios. Promoting pure diversification through regulatory policies should, however, be approached with caution as a review of the literature and SYMBOL simulations suggest that they can have an ambiguous effect on systemic- and bank-level risk insome cases. However, diversification of banks’ sovereign debt holdings can operate as an important mechanism for distributing the impact of shocks, a fact also confirmed in simulations using the QUEST model.

Another form of achieving these positive results is through further cross-border integration of banking sectors. QUEST simulations assuming a particular form of integration (i.e., cross-border bank equity ownership) show how asymmetric shocks may be diluted across regional blocs, increasing the overall welfare of risk-averse households.

Full study on European Commission

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