How banks respond to distress: Shifting risks in Europe's banking union

This paper uses granular bond portfolio data to study how banking systems across the European Union (EU) adjust their asset holdings in response to regulatory solvency shocks. We also study the impact of these shocks at financial intermediaries on the prices of bonds in their portfolio. Despite the creation of a Single Supervisory Mechanism (SSM) in the EU, we find that risk-shifting interacts with regulatory arbitrage motives to explain how banks adjust their portfolios after adverse solvency shocks. After regulatory solvency declines, banks increase their exposure to domestic bonds, including higher yielding but zero risk-weight sovereign bonds. The increase in banking system risk might therefore be even larger than the decline in risk-weighted solvency ratios suggests. Distress in the banking system also feeds back onto bond prices. Bonds owned by less-well capitalized banking systems trade at a discount relative to otherwise similar bonds owned by better capitalized intermediaries.