Sovereign Exposures of European Banks: It Is Not All Doom

Abstract

We investigate whether sovereign bond holdings of European banks are determined by a risk–return trade-off. Using data between 2011 and 2018 for 75 European banks, we confirm that banks exhibited risk-taking behavior during the sovereign debt crisis, e.g., due to moral suasion. In the period 2015–2018, however, banks’ investments in sovereign bonds are characterized by sound risk–return considerations, suggesting a lessening of the doom loop. This result is mainly driven by banks in the core European countries, as banks in the GIPS countries do not exhibit such behavior, nor do they avoid riskier bonds following the sovereign debt crisis.

Does BRRD mitigate the bank-to-sovereign risk channel?

“…In the literature we find extensive research on the existence of the bank-sovereign feedback loop and the two-way risk spillovers between banks and their sovereign [12][13][14][15][16]. To isolate the bank-to-sovereign transmission or bailout channel, [17] use an instrumental variables approach and report an economically meaningful and highly significant impact of bank sector distress on sovereign distress, whilst [18] find evidence for bank-to-sovereign credit rating spillovers.…”