Squaring the Eurozone’s Vicious Circle

SALAMANCA – The eurozone is caught in a diabolical loop, in which weak banking systems harm their sovereigns’ fiscal positions, which in turn compromise the banking system’s stability. But, over the last couple of years, policymakers have focused largely on reducing banks’ impact on their sovereigns – for example, through a Europe-wide supervisory authority and efforts to establish a European resolution mechanism – while ignoring the feedback in the other direction.

Although eurozone sovereign-debt markets have stabilized, the share of sovereign bonds held by domestic banks has increased sharply in the last few months, accounting for more than half of the net increase in debt emissions in some countries. In Spain and Italy, sovereign bonds now account for roughly 10% of banks’ total assets (see graphs below).

The risk is that any unexpected challenge faced by a weaker debtor country’s sovereign-bond market – say, Catalonia’s secession referendum, or the renegotiation of the Portuguese and Greek bailouts – will undermine bank solvency, often even more than in previous rounds of the feedback loop. Moreover, even in the absence of a crisis, the sovereign-bond market’s geographical segmentation hampers monetary-policy transmission substantially.

What accounts for banks’ growing bias toward their own country’s sovereign debt? And what should be done about it?