Role of banks' public debt holdings in the transmission of sovereign stress to the credit market

What is it about?

The euro-area debt crisis and its aftermath are a natural testing ground to assess the role of banks' exposures in the transmission of sovereign stress to the credit market. We study the data generated by the crisis to address two closely related research questions: first, how did banks change their public debt holdings in response to sovereign stress, and how did their response vary depending on their characteristics? Second, did their different sovereign exposures amplify the transmission of stress to their lending?

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Why is it important?

Our findings are important for banking regulation: currently, euro-area prudential regulation gives strong preferential treatment to sovereign debt over bank loans, treating it as risk-free for purposes of capital charges and imposing no concentration limit on holdings. This encourages banks to invest in high-yield sovereign debt rather than lending to firms and households and, as shown in this paper, strengthens the impact of sovereign stress on lending. To make matters worse, in the euro-area countries affected by sovereign stress during the crisis, banks' domestic sovereign exposures have remained considerably larger than they were at the inception of the crisis: between 2013 and 2017, the domestic exposure of the median bank in these countries has been about three times as large as it was in early 2010. Hence, a future resurgence of sovereign stress -- possibly in connection with tapering of large-scale asset purchases by the ECB -- might trigger commensurately larger effects on bank lending.

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