08 April 2014

Angelini/Grande: How to loosen the banks-sovereign nexus

In a column for VoxEU, Paolo Angelini and Giuseppe Grande argue that the 'deadly embrace' between banks and their governments has strengthened with the eurozone crisis, but been mostly been a consequence rather than a cause of it.

This column argues that bank-sovereign negative feedback depends on the economy-wide effects of the sovereign risk, not just the banks’ direct exposure. Loosening the embrace requires sound public finances and well-capitalised, well-supervised banks – including the Banking Union project.

During the crisis, euro area banks’ holdings of domestic government bonds recorded a significant increase, fuelling an intense debate. Several commentators have argued that this surge in ‘home country bias’ has reinforced the bank-sovereign loop, and that it is due to the preferential prudential treatment granted to domestic sovereign, which should therefore be removed.

In most euro area countries, bank holdings of domestic government bonds consistently declined over the decade before the global financial crisis, up until the Lehman default in September 2008. After September 2008 home country bias started to increase in most countries. This coincides with the aggravation of the crisis, well ahead of the outburst of the euro area sovereign debt crisis. Data available for Italy show that these trends have been common to other sectors of the economy.

Clearly, the preferential prudential treatment of sovereign exposures cannot explain these patterns; it may have contributed to the increase in the home country bias during the crisis, but other factors may have had more important effects.  For instance, in this period banks and other financial institutions – fearing a break-up of the eurozone – shifted their asset-liability management from hedging on a currency basis to hedging on a national basis. Also, in the event of a domestic sovereign default, banks would be in serious difficulty, due not only to large direct exposures, but also to the pervasive nature of sovereign risk. For Italy there is evidence that risk-adjusted returns on government bonds have exceeded those on loans since the end of 2011, due to the considerable deterioration of loan quality. This has likely been the case in other countries under stress. Finally, between 2011 and 2012, when wholesale funding markets had all but frozen, banks’ demand for government bonds was fuelled by precautionary hoarding of liquid assets.

The various links between a sovereign debtor and the domestic banking system briefly summarised in the introduction would lead to a hypothesis that the sovereign-bank relationship is “special”. If this were the case, we would expect the credit risk premia of sovereigns to be more closely related to those of banks than to those of non-financial companies. A simple correlation analysis of premia on CDSs suggests that this is not the case. Furthermore, there is no clear structural shift in their patterns following the onset of the sovereign debt crisis at the end of 2009, or since its aggravation in the summer of 2011. This evidence does not allow us to draw any firm conclusions about causality. Nevertheless, it suggests that the risk of a government’s insolvency is a factor that permeates the entire national economy and is transmitted to all of the country’s private institutions.

These considerations do not imply that loosening the banks-sovereign nexus is undesirable. Indeed, there is no doubt that achieving this objective would improve financial stability. In our view, the policy option of imposing tighter prudential rules on banks’ sovereign exposures is viable in a steady state, but complex in a crisis situation. In the present phase, it could be highly procyclical, as it would risk fuelling instability on government bond and bank funding markets; this problem is acknowledged even by the proposal’s advocates, who generally argue for a medium-long term implementation. But even abstracting from this consideration, a revision of the prudential treatment of sovereign exposures would raise a number of concerns.

For the eurozone, the Banking Union project is an essential part of the solution. The announcement of the project in the summer of 2012 marks a structural break in the evolution of the crisis. Almost two years after that announcement, the first step of the project, the SSM, is at an advanced state. It underscores the strong will expressed by European leaders to stick together and to fight redenomination risk. The OMT program announced by the ECB in the summer of 2012 and the continued efforts at the national level have also contributed to push back the perception that the Eurozone was at risk. The recent trends in sovereign bond yields demonstrate that efforts to accelerate the process of European integration are finally bearing fruit. They should be continued in earnest.

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