Developments in the sovereign-bank nexus in the euro area: the role of direct sovereign exposures

Prepared by Silvia Lozano Guerrero, Julian Metzler and Alessandro D. Scopelliti

Published as part of the Financial Stability Review, November 2020.

Rising sovereign debt in the wake of the pandemic has renewed concerns about the euro area sovereign-bank nexus ‒ a major amplifier in the euro area sovereign debt crisis. In the early 2010s, banks in a number of euro area countries held high shares of their government’s debt at the same time that governments were providing guarantees or other support to their banking systems. In recent years, many euro area countries have observed a decline in sovereign-bank interlinkages and, in turn, in the risk of intertwined crises. However, the pandemic and the fiscal measures to support the economy that followed are likely to prompt an increase in sovereign debt, and in turn in the exposures between governments and their banking systems. In addition, the sovereign-bank nexus may develop also via indirect channels, including banks’ exposure to the state of the domestic economy; whereby direct holdings can amplify these indirect effects. This box assesses how the interlinkages, via the direct exposures of banks to sovereign debt securities^[1], have increased so far and whether this has led to an increase in crisis risk.

In 2020 to date, euro area banks’ exposures to domestic sovereign debt securities have risen by almost 19% in nominal amount – the largest increase since 2012.^[2] This reflects banks’ role in absorbing a significant share of the higher issuance of government debt to fund fiscal support measures, as well as banks’ decision to invest the increased amount of deposits in low-risk assets including government bonds (see Chart A, left panel). But the share of total assets invested in domestic sovereign debt securities varies across countries. Since the beginning of 2020, it has increased in a range between 0 and 1.6 percentage points. It is now equal to 11.9% for Italian banks and 7.2% for Spanish banks, but close to 2% for French and German banks.^[3] If banks increase their holdings in line with projected increases in fiscal debt over the next two years, these exposures could increase by a further 0.8-4.7 percentage points of total assets (1.6 percentage points for the euro area), other things being equal. However, the future path of banks’ exposures to domestic sovereign debt securities depends on multiple factors. At the country-level, these factors include the pace of increase of domestic sovereign debt in the coming months and the asset purchases by the Eurosystem (under the PSPP and the PEPP), and at the bank-level, potential carry trade incentives, regulatory compliance with capital and liquidity requirements, as well as collateral needs for the participation in the Eurosystem refinancing operations. Furthermore, before the pandemic, euro area banks were holding a declining share of the sovereign debt securities issued, even after excluding Eurosystem holdings from the outstanding domestic sovereign debt (see Chart A, middle panel).

So far, the vulnerability of banks to higher holdings of sovereign debt securities has been contained because valuation changes have been modest. Monetary policy measures and the proposal for the EU recovery fund in May, reversed initial valuation losses in portfolios of sovereign debt securities (see Chart B, left panel). In addition, less than half (47%) of banks’ exposures to sovereign debt is currently subject to fair value accounting, and in response to the pandemic authorities temporarily reintroduced prudential filters for sovereign debt securities held at fair value through other comprehensive income,^[4] which mitigates the impact of valuation changes on CET1 ratios (see Chart B, right panel).

But with sovereign debt positions expected to remain elevated for some time, vulnerability to valuation changes will persist and other sovereign-bank linkages could also increase. The rise in public debt could be more sizeable in the future if the contingent liabilities from loan guarantee schemes were to materialise, resulting in additional public debt. Domestic banks, especially in countries where governments have higher credit risk and/or banks are less capitalised, could face pressure to support governments under fiscal pressure. Furthermore, independently from direct exposures, an increase in public debt may affect domestic banks also via indirect channels, including a negative impact on their debt financing conditions.