Challenges posed by the sovereign-bank loop in the EU
Day 1 Afternoon
Wednesday 03 April
Grand Ballroom - Roundtable
Objectives of the session
The sovereign debt crisis that erupted in the euro area in 2010 highlighted again the fact that bank risk and sovereign risk are closely intertwined. Sovereigns were indeed exposed to banking risk, and banks were exposed to sovereign risk.
Therefore, the major objective of the Banking Union was to weaken the feedback loop between banks and sovereigns so that increases in banks’ credit risk would no longer be reflected in sovereign risk and, conversely, banks’ financing costs would no longer be driven by their sovereign’s creditworthiness.
The objective of this session is to discuss to what extent this loop has changed since the creation of the Banking Union and to assess the impacts of the quantitative easing policy of the ECB on this issue. Speakers will then be invited to express their views on the essential features of the required solution (fiscal discipline, strengthening of the banking sector, prudential regulatory measures).
Points of discussion
What are the main evolutions in the sovereign-bank loop in the EU?
How to better address the sovereign bank loop in the euro area?
Background of the session
The feedback loop between banks and their sovereigns escalated the financial crisis in Europe into a sovereign debt crisis
The sovereign debt crisis that erupted in the euro area in 2010 highlighted again that bank risk and sovereign risk are closely intertwined. In some countries (Ireland, Spain), the problems arose from a major and unsustainable growth in bank lending, as well as from poor risk management. In these countries, the central government had to provide substantial financial assistance in order to prevent a collapse of the banking sector that would have shaken the whole financial system. In countries where the root cause of the problems was excessive government indebtedness, domestic banks ultimately ensured their sovereign’s access to financing. In both cases the outcome was identical: both banks and the sovereign ended up in significant distress, and external financial assistance was required to solve the problem.
In other words, domestic bank risk can weaken a country’s public finances in case troubled banks require government support, while domestic sovereign risk can weaken bank balance sheets through banks’ holdings of government debt. The feedbacks between bank and sovereign risks can lead to a `doom loop’, as a result of which both banks and their sovereigns can end up in a crisis simultaneously.
The Banking Union was precisely designed to weaken this feedback loop between banks and their sovereigns. 7 years after its creation, it is appropriate to consider whether progress has been made in this area.
Banks’ exposures to their sovereigns are still significant in certain high-indebted countries (Italy, Spain, Portugal)
The ESRB report on the regulatory treatment of sovereign exposure (March 2015) and the CEPR analysis of M. Lanotte and P. Tomasino (February 2018) show that in most euro area countries, euro area sovereign debt exposures of banks (as a proportion of total assets) were considerably larger at the inception of the Economic and Monetary Union than they are now.
After a reduction in the first half of the 2000s, banks in stressed euro area countries have gradually increased their euro area sovereign debt holdings again (as a proportion of total assets) in the last eight years. In contrast, banks from other euro area countries either continued to reduce or stabilised their euro area sovereign debt exposures.
In almost all euro area countries, the euro area sovereign debt exposure of banks is overwhelmingly towards their domestic issuer, and this home bias is particularly strong in the countries where banks’ total euro area sovereign exposure is largest (as a proportion of total assets). Italian banks are the most exposed in Europe, holding €387bn of domestic sovereign debt, equivalent to about 10% of their total assets, according to data from the ECB.
In general, banks in stressed euro area countries increased their exposure to domestic sovereign debt in response to increases in its yield. This response may have been motivated by different factors, including banks’ search for yield by engaging in carry trades that take into account redenomination risk, the desire to increase holdings of liquid assets etc. For a more limited range of countries, there is also some evidence that banks in stressed countries increased their sovereign exposures in response to worsening domestic macroeconomic conditions.
Almost 60 percent of French, German, Italian, and Spanish banking groups’ exposure to euro area sovereigns, for instance, is concentrated in securities issued by the home sovereign. Similarly, 60–80 percent of French, Italian, and Spanish Insurance companies’ investments in sovereign debt are in home-country bonds.
Whatever the motive, the exposure of banks in stressed euro area countries to domestic sovereign debt has increased concurrently with an increase in the risk of such debt, therefore increasing risk in these banks’ balance sheets and reinforcing the banks-sovereign link, which is itself a source of systemic risk.
The sovereign doom loop also affects central banks with large holdings of government bonds purchased as part of QE programs
The quantitative easing policy of the ECB has led to a doubling of the Eurosystem’s balance sheet from €2,150 billion at the end of 2014 to €4,620 billion in September 2018. As a result of the Public Sector Purchase Programme of the ECB, the share of government bonds held by NCBs surged in the last three years from around 5% to 15-20% of total outstanding government bonds.
But this policy has not reduced the vicious circle between Sovereign and banks in euro area highly indebted countries, as explained above. On the contrary, quantitative easing programs encouraged institutions to borrow cheaply from central banks and invest in government bonds with higher returns. In addition, in Italy, the end of the European Central Bank’s QE program and domestic political instability — have increased the problems of financial institutions already laden with significant nonperforming loans.
The linkages between governments and banks are now extended to central banks and this casts a special light on the independence of the central banks.
At the global and EU levels, there is no momentum for changing the regulatory treatment of sovereign exposures
For decades, the regulatory treatment of sovereign debt has significantly discounted and, in many cases, ignored the possibility of default on exposures that are denominated and funded in the country’s own currency.
In most cases, the existing treatment of sovereign exposures is more favourable than other asset classes. Most notably, the risk-weighted framework includes a national discretion that allows jurisdictions to apply a 0% risk weight for sovereign exposures denominated and funded in domestic currency, regardless of their inherent risk. This discretion is currently exercised by all members of the Basel Committee on Banking Supervision. Sovereign exposures are also currently exempted from the large exposures framework. Moreover, no limits or haircuts are applied to domestic sovereign exposures that are eligible as high-quality liquid assets in meeting the liquidity standards. In contrast, sovereign exposures are included as part of the leverage ratio framework.
The Basel Committee published a discussion paper on the regulatory treatment of sovereign exposures in December 2017, but it did not reach a consensus on making any changes to the regulatory treatment of sovereign exposures.
Fiscal discipline should be the essential feature of the required solution
When States are sanctioned by the market because of their excessive indebtedness, and when commercial banks are saddled with huge amounts of sovereign instruments issued by their country, the weakening of State ratings is automatically reflected in banking balance sheets. Fundamentally, the problem comes from lack of fiscal discipline, excess liquidity created by lasting loose monetary policy as well as from the lack of macroeconomic coordination, more than from banking weaknesses. Therefore, fiscal discipline in all parts of the euro area and in particular in high indebted countries would effectively improve sovereign debt sustainability and reduce the risk of sovereign-related distress.