Who's afraid of sovereign bonds?

Abstract

The crisis has underlined the strong interdependence between the euro-area banking and sovereign crises. To understand the role domestic banks have played in holding sovereign debt, a breakdown of government debt by holding sectors is required. The data shows that at the start of the crisis, most continental euro-area countries were characterised by the large size of their banks' portfolios of domestic government bonds, which were markedly larger than in the UK or the US. Consequently, concern about sovereign solvency was bound to have major consequences for banks. The structural vulnerability of euro-area countries has increased, reinforcing the sovereign/ banking crisis vicious cycle. All countries for which concerns about state solvency arose in recent years have seen a reversal in the previously steady increase of the share of government debt held by non residents. Germany, by contrast, has seen an increase in the share held by non residents. In the short term, these observations raise a question about the effectiveness of ECB provision of liquidity to banks as a means to alleviate the sovereign crisis. At a point when government bonds are considered risky assets, euro-area banks are faced with both balance sheet and reputational risks compared to their non-euro area counterparts, and may prove reluctant to increase this exposure further. In the longer term, the question is if and how euro-area regulators should set incentives to reduce banks' heavy exposure to sovereigns. This issue should be given more attention in European policy discussions on how to strengthen the euro area.

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