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The Bank-Sovereign Loop and Financial Stability in the Euro Area

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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.

Suggested Citation

  • Langedijk, Sven & Fontana, Alessandro, 2019. "The Bank-Sovereign Loop and Financial Stability in the Euro Area," Working Papers 2019-10, Joint Research Centre, European Commission (Ispra site).
  • Handle: RePEc:jrs:wpaper:201910
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    File URL: http://publications.jrc.ec.europa.eu/repository/bitstream/JRC115569/jrc115569_sovereign_bank_feedback_fontana_langedijk_final.pdf
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    1. repec:oup:ecpoli:v:27:y:2012:i:70:p:199-230 is not listed on IDEAS
    2. Riccardo Lisa & Stefano Zedda & Francesco Vallascas & Francesca Campolongo & Massimo Marchesi, 2011. "Modelling Deposit Insurance Scheme Losses in a Basel 2 Framework," Journal of Financial Services Research, Springer;Western Finance Association, vol. 40(3), pages 123-141, December.
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    More about this item

    Keywords

    Credit Risk; Banks; Sovereign; Financial Stability; ESM; Direct Recapitalisation;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • H81 - Public Economics - - Miscellaneous Issues - - - Governmental Loans; Loan Guarantees; Credits; Grants; Bailouts

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