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The Bank-Sovereign Loop and Financial Stability in the Euro Area

Sven Langedijk and Alessandro Fontana

No 2019-10, JRC Working Papers in Economics and Finance from Joint Research Centre, European Commission

Abstract: We propose a simple model that captures the link between bank and sovereign credit risk. It allows evaluating policy options to address this ‘doom loop’ in which the government may need to raise debt to recapitalise banks, and an increase in government debt raises sovereign risk and in turn generates potential bank losses via their (sovereign) bond holdings. Hence, an initial shock originating either in the banking or sovereign sector is amplified by the feedback relation. We set up a framework based on detailed actual bank balance sheets and test the model on 35 large EU banking groups, across 7 European countries. The effects of the feedback loops in most cases more than double the effect of the initial shock on bank losses and the sovereign risk premium. We show that a single EU bank resolution mechanism, European Stability Mechanism (ESM) direct bank recapitalisations, and bondholder “bail-in” can be effective to dampen the bank-sovereign loop. Addressing the home bias in banks sovereign bond holdings by reducing excessive exposure to domestic sovereigns has only limited benefit in terms of lower crisis doom loop effects as contagion effects increase.

Keywords: Credit Risk; Banks; Sovereign; Financial Stability; ESM; Direct Recapitalisation (search for similar items in EconPapers)
JEL-codes: E44 G01 G21 H63 H81 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2019-05
New Economics Papers: this item is included in nep-ban, nep-eec and nep-mac
References: Add references at CitEc
Citations: View citations in EconPapers (1)

Published by Publications office of the European Union, 2019

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Persistent link: https://EconPapers.repec.org/RePEc:jrs:wpaper:201910

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