Monetary Policy Bank Bailouts And The Sovereign Bank Risk Nexus In The Euro Area

The paper analyses the empirical relationship between bank risk and sovereign credit risk in the euro area. Using structural VAR with daily financial markets data for 2003-13, the analysis confirms two-way causality between shocks to sovereign risk and bank risk, with the former being overall more important in explaining bank risk, than vice versa. The paper focuses specifically on the impact of non-standard monetary policy measures by the European Central Bank and on the effects of bank bailout policies by national governments. Testing specific hypotheses formulated in the literature, we find that bank bailout policies have reduced solvency risk in the banking sector, but partly at the expense of raising the credit risk of sovereigns. By contrast, monetary policy was in most, but not all cases effective in lowering credit risk among both sovereigns and banks. Finally, we find spillover effects in particular from sovereigns in the euro area periphery to the core countries.

This paper reviews empirical and theoretical work on the links between banks and their governments (the bank-sovereign nexus). How significant is this nexus? What do we know about it? To what extent is it a source of concern? What is the role of policy intervention? The paper concludes with a review of recent policy proposals.

This paper reviews empirical and theoretical work on the links between banks and their governments (the bank-sovereign nexus). How significant is this nexus? What do we know about it? To what extent is it a source of concern? What is the role of policy intervention? The paper concludes with a review of recent policy proposals.

We explore the effects of the ECB's unconventional monetary policy on the banks' sovereign debt portfolios. In particular, using panel vector autoregressive (VAR) models we analyze whether banks increased their domestic government bond holdings in response to non-standard monetary policy shocks, thereby possibly promoting the sovereign-bank nexus, i.e. the exposure of banks to the debt issued by the national government. Our results suggest that euro area crisis countries' banks enlarged their exposure to domestic sovereign debt after innovations related to unconventional monetary policy. Moreover, the restructuring of sovereign debt portfolios was characterized by a home bias.

The sovereign-bank nexus played a key role in the 2009-12 European debt crisis by enabling pernicious dynamics whereby governments and domestic banking sectors mutually enfeebled each other. This paper reviews the direct (financial) channels and the indirect (real) channels through which banks and sovereigns interact, and that can give rise to feedback loops between the two sectors. While significant progress has been achieved in mitigating the direct channel of the loop in recent years, the indirect mechanisms of the loop stayed largely intact. Policy options for improving the financial stability of both banks and sovereigns across the euro area have been discussed, including measures to increase the diversification of banks' sovereign debt holdings. Focusing on diversification as a standalone measure, a review of the literature and model-based simulations suggest an ambiguous impact on systemic risk. However, in those cases where diversification can either reduce total risks or keep them unchanged, it can also deliver an important shock absorption effect in crisis periods. In such cases, simulations show that higher cross-border integration of banking sectors would dilute the impact of asymmetric shocks across the regions of a monetary union, thus increasing the overall welfare of risk averse households.

Is the transmission of monetary policy to bank lending heterogeneous across euro area countries? This paper employs annual bank level data to test whether the bank lending channel of monetary policy was heterogeneous in the euro area over the period 2007-2016. To do so it follows a simple procedure that allows direct testing of how monetary policy affected similar banks located in different countries. Results indicate that the transmission of monetary policy to bank lending was heterogeneous across countries that were differently exposed to the sovereign debt crisis. On average, the same 1% cut in the policy rate led to a 1.6% increase in lending by banks located in non-stressed countries as opposed to a 0.4% increase for banks located in countries under severe sovereign stress. Unconventional monetary policy - as captured by the ECB shadow rate - was also unevenly transmitted to bank lending. Exposure to sovereign risk is identified as a key source of heterogeneity. Within stressed countries, banks with larger sovereign exposures reacted to monetary easing by expanding lending by less than banks with smaller exposures. As a result, monetary accommodation was smoothly transmitted to lending only by banks with limited exposure to sovereign risk. In response to the same 1% policy rate cut, the credit expansion of highly exposed stressed countries banks was instead 2.75% weaker than that of banks in non-stressed countries. These findings support existing evidence on sovereign risk having direct adverse consequences for bank lending and highlight the extent to which sovereign risk aggravated heterogeneities in the transmission on monetary policy to the real economy via the banking system during the euro area debt crisis.

We investigate the time varying dynamics of the linkages between sovereign and bank default risks over the period 2006-2015, using the credit default swap (CDS) spreads of the bonds of major international banks and of sovereign issuers as indicators of risk within four major European countries. The nexus between bank risk in core countries and sovereign risk of peripheral countries is also analyzed, under the hypothesis that higher bond yields and preferential treatment of bond issued by euro sovereigns under Basle II may have favored the stocking of peripheral sovereign bonds in core bank portfolios. The use of a time-varying regime switching correlation analysis, the STCC-GARCH, allows to identify the economic variable behind the state shifts, the so-called “transition variable”, and to date precisely the changes in the size of the correlations that are due to shocks (viz. the Lehman crisis, the evolution of the Greek crisis) or to unconventional monetary policies such as Quantitative Easing and TLTRO.

We analyze holdings of public bonds by over 20,000 banks in 191 countries, and the role of these bonds in 20 sovereign defaults over 1998-2012. Banks hold many public bonds (on average 9% of their assets), particularly in less financially-developed countries. During sovereign defaults, banks increase their exposure to public bonds, especially large banks and when expected bond returns are high. At the bank level, bondholdings correlate negatively with subsequent lending during sovereign defaults. This correlation is mostly due to bonds acquired in pre-default years. These findings shed light on alternative theories of the sovereign default-banking crisis nexus.

We develop a two-country model with an explicitly microfounded interbank market and sovereign default risk. Calibrated to the core and the periphery of the Euro Area, the model gives rise to a debt-banks-credit loop that substantially amplifies the effects of financial shocks, especially for the periphery. We use the model to investigate the effects of a stylized public asset purchase program at the steady state and during a crisis. We find that it is more effective in stimulating the economy during a crisis, in particular for the periphery.