Italian and French banks rekindle fears of a “catastrophic loop” with the purchase of bonds

Updates from European banks

The exposure of Italian and French banks to the sovereign debt of their own countries has reached record levels since the start of the pandemic, rekindling fears about the sector’s links with increasingly indebted governments.

Domestic government securities and loans held by euro area banks rose from more than 140 billion euros to just over 2.1 billion euros in the year through February, according to Financial Times calculations based on European Central Bank data.

The exposure of Italian banks to the national public debt hit a record 712 billion euros last August, up more than 9% from February and down slightly since then. French banks saw the biggest post-pandemic increase in their exposure to their own government, which hit a record € 431 billion in September, a jump of more than 18% since February.

The closer ties between banks and their national governments have rekindled concerns about a loophole in the European monetary union that was exposed during the region’s sovereign debt crisis a decade ago.

At that time, the banks’ extensive exposure to national sovereign debt created a “catastrophic loop” as a vicious cycle between private sector lenders and governments weakened and ultimately threatened the existence of the single currency area.

“Sovereign risk on bank balance sheets has still not been addressed, unlike other risk mitigation measures introduced by the [eurozone] banking union “, noted Heike Mai, Bank Analyst at Deutsche Bank. “There is still the elephant in the room. The current pandemic with its soaring public debt highlights the need for reform. “

The region’s sovereign-bank connection is back on the agenda in Brussels as the European Commission conducts a public consultation to examine potential reforms to the EU’s financial crisis management tools and insurance framework bank deposits.

“The increase in liabilities between banks and governments worries me and policymakers should seek to address it,” said Nicolas Véron, senior researcher at the Bruegel think tank in Brussels. “But the risk seems a little beyond the horizon that keeps policymakers awake these days.”

Eurozone governments have issued a record amount of bonds last year to fund their response to the pandemic, for the first time sending the bloc’s debt above 100% of gross domestic product.

But huge bond purchase by the European Central Bank lowered borrowing costs for eurozone governments to near all-time lows, combined with the EU’s deal on a stimulus fund to provide $ 750 billion euros in grants and loans to the hardest hit countries.

Line graph of euro area banks' exposure to debt securities and domestic government loans (in billions of euros) showing that Europe's catastrophic loop is widening again

“Banks must react to the issuance of bonds by the state because they believe it is a good investment to hold in terms of risk and they are encouraged to do so to maintain liquidity,” said Jacques de Larosière , former director of the IMF. and Banque de France.

Banking regulations view sovereign debt as a risk-free investment for banks, allowing them to allocate zero capital to these assets. By borrowing money from the ECB at a price as low as minus 1%, there is an easy “carry trade” for banks who can make money by buying government bonds.

Lorenzo Bini Smaghi, chairman of French bank Societe Generale, said regulators could incentivize lenders to buy government bonds by allowing only those with high capital levels to restart dividend payments. “Banks may want to invest primarily in safe assets to protect capital levels given the message from regulators,” he added.

As the exposure of euro area banks to their own government debt has declined since Greece’s last international bailout in 2015, it started to climb again after the pandemic struck a year ago – especially among Italian and French lenders.

Representing 18 percent of their total assets and almost double their total capital, Italian banks are much more exposed to their own public debt than others in Europe.

Bank of Italy noted the share of the country’s government bonds held by foreign investors fell from 25.9% to 23.6% in the first six months of last year, while Italian banks increased their share by 16.9% at 18.6%.

The domestic sovereign exposure of French banks remains well below the euro zone average at only 4% of their total assets and two-thirds of their equity.

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