Sovereign exposures of European banks: it is not all doom

In this paper we investigate whether or not observed changes in the composition of the sovereign bond portfolios of European banks are determined by a risk-return trade-off. Banks have been shown to disproportionally invest in bonds issued by their domestic sovereign, causing a negative bank-sovereign doom loop. Several motivations for such behavior have been demonstrated in the extant literature, such as e.g., search for yield or moral suasion, which from an investment perspective all involve some degree of irrational behavior. We depart from this approach and investigate the risk-return trade-off in the bank sovereign bond portfolios. We use data from all stress tests and transparency exercises conducted by the EBA between 2011 and 2018 for a sample of 76 European banks. Using the Sharpe ratio for the risk-return assessment, we find that over the entire period banks investments and divestments of sovereign bonds are characterized by rational risk-return considerations. Moreover, both bond risk (measured by the standard deviation of bond returns) as well as sovereign risk (sovereign CDS spreads) are negatively related to bond buying, implying that, on average, banks do not engage in excessive risk-taking behavior in their sovereign bond portfolios. Our main conclusion is that over the 2011-2018 period banks may have exhibited spells of excessive risk behavior in their sovereign bond buying, but over the entire period their sovereign bond investments exhibit a sound risk-return trade-off. These findings have implications for policy initiatives to tackle concentrations in sovereign bond holdings by European banks.