Banks' holdings of and trading in government bonds

In this paper we examine the holdings of government securities by domestic banks along those of the foreign banks/non‐banks/official sector as well as the domestic central bank and domestic non‐banks, using data for 21 advanced economies from 2004Q1 to 2016Q2. The research offers four main insights. Firstly, banks are reluctant to undertake large changes in their holdings of domestic bonds but do accept frequent changes of more intermediate size. Secondly, the foreign official sector emerges as the clearest example of contrarian investor, which buys when prices fall and sells when prices rise. Thirdly, the yields of 10‐year benchmark sovereign bonds tend to be lower the larger the holdings by domestic and foreign banks are. Finally, we find in all countries of the sample a positive home bias in banks' sovereign holdings while foreign banks hold less than predicted by a neutral portfolio measure. These results suggest that banks regard domestic government bonds as a special asset class (hence the positive bias and the avoidance of large changes in inventories) which they manage in a flexible manner (hence the frequent intermediate changes and the lack of systematic timing of transactions) probably to meet requests from their customers. All in all, this behavior by domestic banks provides a positive contribution to the liquidity of the market as a whole.