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The European sovereign debt crisis has strengthened debate over the link between sovereign and banking risk. Uncertainty around the creditworthiness of some governments in the Eurozone has translated into higher instability of the banking systems.
The interdependence between banking and sovereign risk may be the result of a two-way causality. On the one hand, higher banking risk translates into higher sovereign risk because the possibility that a given government has to rescue the domestic banking system becomes more likely. On the other hand, a deterioration of sovereign creditworthiness impacts negatively on banks’ assets.
In conclusion, the analysis of banks’ balance sheets has shown a common tendency of banks in the eurozone to reduce their level of holdings of periphery country sovereign debt during much of 2011. In particular, due to the home-biased composition of government debt portfolios of banks, such reduction has been massive for banks located in Greece, Ireland, Italy, Portugal and Spain. With the LTRO, however, these trends have been reversed. The holdings of sovereign debt poorly explain the performance of bank stock prices in 2011. Rather, the financial market seems to incorporate the country risk associated with the location of the individual banks.