Title: The Bank-Sovereign Loop and Financial Stability in the Euro Area
Authors: FONTANA ALESSANDROLANGEDIJK SVEN
Publisher: Publications Office of the European Union
Publication Year: 2019
JRC N°: JRC115569
ISBN: 978-92-76-02955-7 (online)
ISSN: 2467-2203 (online)
Other Identifiers: OP KJ-AE-19-010-EN-N (online)
URI: http://publications.jrc.ec.europa.eu/repository/handle/JRC115569
DOI: 10.2760/81563
Type: EUR - Scientific and Technical Research Reports
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.
JRC Directorate:Growth and Innovation

Files in This Item:
File Description SizeFormat 
jrc115569_sovereign_bank_feedback_fontana_langedijk_final.pdf1.56 MBAdobe PDFView/Open


Items in repository are protected by copyright, with all rights reserved, unless otherwise indicated.