Publication - Home bias in bank sovereign bond purchases and the bank-sovereign nexus, by Desislava C. Andreeva, Thomas Vlassopoulos
"At this point the bankers can tell themselves: o¢ cially these assets are safe, and if not, then we will be bankrupt anyway, so why not borrow more and invest more to earn even greater proÖts in the likely event that all the worriers are wrong.[...] We have seen such a process unfolding [...] for sovereign debt in the euro zone." Myerson (2014)
During the euro area sovereign debt crisis of 2011/2012, yields on sovereign bonds issued in vulnerable countries rose dramatically. For euro area banks this development o§ered a potentially proÖtable investment opportunity: they could obtain low-cost short-term funding from the central bank and acquire high-yielding sovereign bonds issued in vulnerable countries - an investment strategy dubbed the "carry trade in peripheral bonds".
While this possibility was in principle open to all euro area banks, in fact only banks in vulnerable countries pursued it. Importantly, these banks acquired bonds issued by their domestic governments. This paper argues that the "home bias" in sovereign bond purchases during the sovereign debt crisis resulted from the fact that domestic banks priced the credit risk embedded in vulnerable government bonds di§erently than their non-domestic peers. This di§erentiated pricing, in turn, originated from the existence of a sovereign-bank nexus, i.e. a close relationship between the creditworthiness of the bank and that of its respective government.
Non-domestic banks tended to regard the higher yields during the crisis on sovereign bonds issued in vulnerable countries as reáecting an increase in the corresponding riskiness of the bonds. In risk-adjusted terms, which is the relevant perspective for portfolio allocation decisions, the return from the carry trade in peripheral bonds was, therefore, very low for them, if positive at all. By contrast, for domestic banks and in the presence of a sovereign-bank nexus, the credit risk on sovereign bonds materialises in states of the world in which they would very likely be insolvent anyway. This can be the case, for instance, because the banks have already lent to the sovereign directly or because they are both heavily exposed to the state of the domestic economy. Moreover, sovereigns serve as the ultimate backstops in a domestic banking crisis, providing deposit insurance and capital injections to contain systemic risk. A sovereignís inability to play this role would most likely lead to an implosion of the domestic banking system.
Regardless of the precise reasons for which a sovereign-bank nexus was present during this episode, its existence resulted in domestic banks not fully pricing in their sovereignís credit risk when making portfolio allocation decisions. This is because as the credit losses arise in a situation where the banks are anyway insolvent, they are e§ectively partly borne by the banksícreditors. The banksíshareholders, however, earn the full credit premium in all the states of the world where the sovereign does not default.
Using a simple theoretical model, therefore, this paper illustrates that incentives to invest in domestic sovereign debt are stronger when, Örst, the probability of default of the domestic sovereign is higher and, second, the bank-sovereign nexus is stronger. In the Örst case the credit risk premium that can be earned is larger, while, in the second, a greater portion of credit risk is shifted to bank creditors. The main part of this paper tests the empirical validity of this hypothesis using data on individual euro area banksípurchases of domestic sovereign bonds. Our empirical analysis focusses in particular on the last quarter of 2011 and the Örst quarter of 2012, when two longer-term reÖ- nancing operations with a maturity of three years were announced and conducted by the ECB. In this period larger domestic sovereign bond purchases were made by banks whose creditworthiness correlates more strongly with the one of the domestic sovereign (measured by respective CDS spreads) and for sovereign bonds with higher CDS spreads.
This Önding continues to hold when taking into account an array of other factors that are likely to ináuence banksídecisions to acquire government bonds. This incentive mechanism is, however, not relevant on average over the entire sample considered (spanning 2008 Q1 to 2015 Q2), as it requires the coexistence of non-trivial levels of sovereign credit risk and a material intensity of the bank-sovereign nexus in order to surface. In the presence of these conditions, domestic sovereign debt o§ers ex ante higher returns to bank shareholders than alternative ways to build up precautionary liquidity bu§ers or indeed to execute carry trades, such as to invest in non-domestic government bonds. According to the analysis presented in this paper, the existence of a sovereign-bank nexus results in an incomplete internalisation of credit risk for domestic sovereigns that, in turn, leads to home bias in sovereign bond purchases.
To the extent that this reinforces the sovereign-bank nexus, policy should aim to tilt banksírisk-return calculus so that domestic sovereign bond credit risk is taken into account more fully. By weakening the bank-sovereign nexus, policy initiatives already underway under the Banking Union agenda should contribute in this direction.
Copyright: European Central Bank
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