(This post is thanks to Editor Thorsten Beck)
The lead article in Volume 21, issue 6 of the Review of Finance is “Bank Exposures and Sovereign Stress Transmission” by Carlo Altavilla, Marco Pagano and Saverio Simonelli. The link between sovereign and bank distress has been at the core of the Eurozone crisis, and several papers have addressed the causes of banks’ concentration on domestic sovereign bonds and the repercussions of this concentration for banks’ lending activity and for the real economy. The authors can rely on bank-level data on sovereign bond holdings to differentiate between different hypotheses.
The Sovereign-Bank Link
One important question throughout the Eurozone crisis has been why banks have chosen to increase their holdings of domestic sovereign bonds during the crisis, especially in the face of increasing sovereign distress in some countries, and how such behavior varied across bank with different characteristics. The moral suasion hypothesis claims that distressed governments lean on “their” banks to buy more sovereign bonds and thus reduce funding costs. The alternative – though not exclusive – carry trade hypothesis claims that banks used cheap ECB funding to buy high-yielding sovereign bonds. Using variation in bank circumstances and the different behavior of banks in stressed and non-stressed Eurozone countries allows the authors to distinguish between these two hypotheses. Furthermore, exploiting the bank-specific dynamics of exposures enables them to quantify their contribution to the transmission of sovereign stress to lending.
Data and Identification
The authors have monthly data available on private sector lending and domestic vs. foreign sovereign bond holdings for a sample of 226 unconsolidated Eurozone banks from 2007 to 2015, capturing – on average – 70% of a country’s banking system. The sample contains both parent banks, domestic subsidiaries and foreign subsidiaries, when present in a bank group. The unconsolidated nature of the data allows the authors to control for demand and identify the supply-side relationship between sovereign bond accumulation and private sector lending of banks. Specifically, as sovereign bond holdings are undertaken at the parent bank level, this can be regarded as exogenous to loan demand for foreign subsidiaries’ private sector lending.
- Government-owned banks and banks that benefitted from government bail-outs during the crisis were more likely to accumulate domestic sovereign bonds after the start of the Eurozone crisis than other banks when bond prices decrease, while such a difference did not exist in non-stressed countries. This supports the moral suasion hypothesis.
- Banks with low regulatory capital were more likely than other banks to accumulate domestic sovereign bonds after the start of the Eurozone crisis when bond prices decreased, while such a difference did not exist in non-stressed countries. This supports the carry trade hypothesis.
- The ECB liquidity injections in 2011 and 2012 reinforced the moral suasion channel, enabling public banks to buy more sovereign debt, but not the “carry trade” channel.
- Stressed-country banks with larger sovereign exposures cut lending more deeply than less exposed banks when sovereign stress increased.
- This effect is amplified across borders, as foreign subsidiaries of stressed country parent banks also reduce private sector lending in non-stressed host countries. As discussed above, this also suggests that the link between sovereign distress and private sector lending is driven by supply and not demand-side effects.
Both moral suasion by stressed country governments and the search for yield enticed banks in stressed countries to load up on domestic sovereign bonds. This had a negative result on private sector lending, including cross-border spill-over effects to non-stressed countries, and was partly fueled by the ECB providing long-term funds to the banking system to buy sovereign bonds. It shows that banks’ incentives regarding their sovereign bond holdings and attempts to address sovereign stress exacerbated the recession in many stressed countries as banks cut back on lending. It also points to a regulatory bias as sovereign bonds are not subject to capital charges and banks do not face any concentration limits in their sovereign bond holdings. The results of this paper certainly provide important lessons for Eurozone reform and future crisis management.