Abstract
AbstractEuropean banks have been criticized for holding excessive domestic government debt during the recent Eurozone crisis, which may have intensified the diabolic loop between sovereign and bank credit risks. By using a novel bank‐level data set covering the entire timeline of the Eurozone crisis, I first reconfirm that the crisis led to the reallocation of sovereign debt from foreign to domestic banks. In contrast to the recent literature focusing only on sovereign debt, I show that the banks' private‐sector exposures were (at least) equally affected by the rise in home bias. Consistent with this pattern, I propose a new debt reallocation channel based on informational frictions and show that the informationally closer foreign banks increase their relative exposures when the sovereign risk rises. The effect of informational closeness is economically meaningful and robust to the use of different information measures and controls for alternative channels of sovereign debt reallocation.
Highlights
Can domestic banks act as lightning rods for government bonds in the midst of a financial storm? On the contrary, the diabolic loop between sovereign and bank credit risks has been very well documented
I illustrate that, in response to crisis, private forms of debt in bank balance sheets have experienced an large jump in home bias, tilting towards a more general explanation of the home bias rather than the specific ones applied to sovereign debt in the recent literature
Before I lay out my main analysis and show how information channel -in interaction with sovereign risk- may affect banks’ government bond holdings, I start by presenting several empirical patterns which I find a bit difficult to fully reconcile with the existing mechanisms explaining the rising home bias in the context of Eurozone crisis
Summary
Can domestic banks act as lightning rods for government bonds in the midst of a financial storm? On the contrary, the diabolic loop between sovereign and bank credit risks has been very well documented. A spike in the sovereign credit risk might trigger a deterioration in the banking sector through losses on banks’ government bond holdings and the loss of credibility for future government support (Acharya, Drechsler, and Schnabl, 2014) Despite this adverse feedback mechanism, the link between governments and their domestic banks may have a silver lining: local banks might have soft information advantages regarding their clients thanks to their “daily exposure to local news stories, firsthand knowledge of the local economy, and personal relationships with key people at the issuing body” (Butler, 2008). A role for soft private information and the resulting panic by less informed agents are consistent with the evidence that government bond spreads moved in a self-fulfillingly pessimistic way during Eurozone crises and fell out of touch with publicly observable hard information regarding the solvency of individual countries (De Grauwe and Ji, 2013; Saka, Fuertes, and Kalotychou, 2015)
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