Eurozone banks hold large amounts of domestic sovereign-issued bonds on their books.
Flash Economics Economic Research analyst Patrick Artus examines the implications of the transition, from a bailout regime to bail-in, on Eurozone banks’ holdings of these bonds.
Definitions
Eurozone Bailout regime:
A situation where banks losses are covered by the government. Government bonds held by banks are a sovereign risk, not a banking risk. This is because if the value of these bonds crashed, the government would need to bailout the banks for the loss. The increased risk would cause interest rates on government bonds to rise compared to bank issued bonds.
Eurozone Bail-in regime:
The current situation when a bank’s risk is borne by its shareholders and creditors. Purchases of government bonds by banks could increase their banking risk. On the other hand the demand by the banks pushes down the interest rate on government bonds. Logically, therefore, the interest rates on government bonds should diverge (move oppositely) from bank bond interest rates.
Current holdings of government bonds
Banks in Spain and Italy have very high holdings of government bonds when computed as a percentage of GDP.
Observations for Eurozone
During the era of bailouts (2002-2012), the analyst observed:
• “Bank and sovereign CDS were highly and positively correlated without there being any clear causality from banking risk to sovereign risk;
• There was a link between increases in banks’ government bond holdings and increases in sovereign risk in Spain and Italy.”
This is apparent from the correlation table below:
Italy
The country was picked for this example because of the risk profile of its government bonds.
Bailout regime:
The charts below show the movements in the 5-year rates for Sovereign and Bank CDS and the quantum of government bonds held by Italian banks during the aforesaid period of 2002-2012.
The following is the correlation table between Bank and Sovereign CDS for Italy during the bailout regime period.
Transition to bail-in regime:
The analyst observes that in the case of a bail-in regime, in Italy, the correlation between bank CDS and sovereign CDS has fallen substantially compared to the correlation prevailing during the bailout regime.
Conclusion
The fall in correlation confirms the view that in a bail-in regime, an increase in the holding of risky government bonds by banks should lead the interest rates on bank bonds and government bonds to move in opposite directions.
