The sovereign-bank nexus in the euro area: financial and real channel

The sovereign-bank nexus played a key role in the 2010-2012 European debt crisis by enabling pernicious dynamics whereby governments and domestic banking sectors mutually weakened each other. This article reviews the direct (financial) and indirect (real) channels through which banks and sovereigns interact, and which can give rise to feedback loops between them. While significant progress has been achieved in recent years in mitigating the direct channel, its indirect mechanisms have remained largely intact. Policy options for improving the financial stability of euro area banks and sovereigns continue to be discussed in policy circles, including measures to diversify banks? sovereign debt holdings. While a review of the literature and model-based simulations do not demonstrate that diversification in itself has a clear impact on systemic risk, where it does reduce (or at least cap) total risks it can help significantly in absorbing shocks in crisis periods. Similarly, simulations show that greater cross-border integration in banking can dilute the impact of asymmetric shocks across regions in a monetary union.