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The banking crisis as a giant carry trade gone wrong

A pernicious aspect of the Eurozone crisis is the ‘doom loop’ linking European banks and governments. This column argues that poor European policy choices in the wake of the 2008 Global Crisis worsened the problem. Rather than being forcefully recapitalised as in the US and UK, many Eurozone banks were left undercapitalised and free to gamble for redemption. In what may be the greatest carry trade ever, they borrowed cheap, first in short-term debt markets and then from the ECB, to invest in high-yield but risky sovereign debt. Substantial bank recapitalisations against sovereign-bond losses is the way forward.

The health of the European financial system is intimately tied to the health of European sovereigns through the holdings of the sovereign debt (Angeloni and Wolff 2012; Acharya, Drechsler and Schnabl 2013). Traditionally, banks have been major holders of domestic sovereign debt, but in Europe there are substantial cross-country sovereign holdings.

For several years until 2008, credit markets did not reflect substantially the economic differences between the countries in the Eurozone. This resulted in a high co-movement in, and very similar levels of, borrowing costs for these countries. This apparent ‘convergence’ of the Eurozone countries, however, reversed itself starting 2008. Figure 1 shows this time-series patterns for Spanish and German government bond yields as an example. The vertical red lines indicate that the divergence in the borrowing costs arises substantially before the actual rating downgrades of Spanish government bonds by Standard & Poor’s in 2010 and 2011.

As the health of the sovereigns became a concern, investors also questioned the health of the banking system. The rising sovereign yields threatened the solvency of European banks and caused a flight-to-quality of bank investors as they became unwilling to refinance the banks’ sovereign portfolios. Figure 1 illustrates this flight-to-quality through the drop in German bund yields particularly in 2011 as the Spanish yields widened – a strong negative correlation unlike the positive co-movement earlier. This in turn created significant liquidity problems for banks that were heavily reliant on short-term wholesale funding (such as from the money market funds in the US).

Why were banks so exposed to this risk of divergence between the southern periphery sovereigns and the other Eurozone countries?

Figure 1. Government bond yield spreads: Spain vs. Germany

New research: The carry trade interpretation

Acharya and Steffen (2013) explain that some banks were ex ante willing to take this downside risk by investing in long-term risky sovereign debt of the Eurozone’s periphery (Greece, Ireland, Italy Portugal, and Spain – GIIPS) and financing these investments with short-term wholesale funding.

  • If this trade is successful, the banks pocket the ‘carry’ (consisting of greater interest income from risky debt as well as an increase in value of the risky sovereign bonds when their yields decline).
  • If the trade fails, as it did in 2011, they lose as GIIPS sovereign-bond yields increase further and in response the access to short-term funding dries up for those holding these bonds.

Figure 1 shows that yield spreads between GIIPS’ sovereign debt and German bunds had widened to 50-100 basis points already as of mid-2008 and eventually diverged by more than 400 basis points in 2011.

Acharya and Steffen (2013) show that banks were actively managing their portfolio of GIIPS sovereign bonds by increasing positions until the end of 2010, even as the relative spreads between GIIPS and German bund yields had already widened. We focus below first on the case of Dexia and then on the overall evidence for Eurozone banks.

A carry trade gone wrong

Dexia SA (Dexia) is a quintessential example of this carry trade behaviour:

  • Using its high rating from Moody’s and Standard & Poor’s, Dexia was able to fund its €630 billion balance sheet in 2008 with 43% short-term wholesale debt.
  • On the asset side, Dexia built a proprietary €203 billion bond portfolio (about 32% of its balance sheet); GIIPS sovereign debt amounted to five to six times its book equity at that time.

Since Dexia was a public sector lender (which was a low margin business), these non-core trading activities contributed substantially to Dexia’s profitability.

Dexia had to be bailed out for the first time in 2008 during the financial crisis (somewhat unfortunately as we explain, with huge debt guarantees rather than through a forceful recapitalisation). Dexia, however, remained economically vulnerable as it was holding a portfolio of GIIPS sovereign bonds amounting to €26.1 billion as of 31 March 2010 consisting mainly of Italian bonds (€17.6 billion) and Greek government bonds (€3.7 billion) as shown in Table 1.1 Moreover, Table 1 shows that until September 2011, it maintained its risky sovereign-bond portfolio at roughly the same levels.

Table 1. Dexia’s exposure to GIIPS sovereign debt (million euros)

This vulnerability to the health of southern Eurozone countries contributed to a run of institutional investors. The run started when both Moody’s and Standard & Poor’s put Dexia on watch for possible downgrade because of their significant holdings of peripheral sovereign debt.

  • US Money Market Mutual Funds were among the first institutional investors who pulled their money out of European banks.

Figure 2 illustrates that US Market Mutual Funds withdrew about $10 billion from Dexia within three months in Summer 2011 precipitating a further stock-price decline.

  • Overall, Dexia lost about €80 billion in deposits and short-term funding between March and October 2011;

Moreover, Dexia hedged its long fixed interest-rate exposure in the Total Return Swap market, by effectively shorting German bunds. The decline in bund yields caused margin calls of more than €15 billion further contributing to Dexia’s liquidity problems. As Dexia’s swap counterparties were unknown, the French, Belgian and Luxembourg governments bailed out Dexia a second time in October 2011 highlighting the systemic importance of this bank.

Pierre Mariani, the chairman of the management board and CEO of Dexia SA, summarised the causes of Dexia’s solvency and liquidity problems in an earnings call on 23 February 2012:

“And of course, the deterioration of the Eurozone situation and particularly the sovereign crisis in the peripheral economies hit very badly the group. And that’s of course not a surprise for a group that still had very important short-term funding needs that was mainly present in strong exposures in peripheral countries... Before 2008, it was the group’s high rating granting easy access to wholesale funding that led to the situation of October 2008 with short-term funding need of €260 billion outstanding in October 2008, i.e. 43% of total balance sheet… with very significant acceleration and buildup of the bond portfolio was amounting at €203 billion at the end of 2008. Mostly carry trades with marginal improvement of customer access… that led to a very significant gearing ratio because the portfolio size was, at that time, 25 times the group equity”.

Figure 2. Dexia’ share price and US money market fund withdrawals

Solvency and liquidity risk of European banks reflects a carry trade behaviour

Dexia-style ‘carry trade’ behaviour was pervasive among European banks. Table 2 reports aggregate portfolio holdings of 56 publicly traded European banks that participated in the stress tests and the capitalisation exercise conducted by the European Banking Authority since March 2010 for GIIPS versus non-GIIPS banks. Interestingly, even as sovereign spreads widened in 2010, both GIIPS and non-GIIPS banks increased their holdings in risky Italian and Spanish sovereign debt as highlighted in the Table 2.

Table 2. Portfolio Holdings (million euros)

As yield spreads continued to widen further in 2011, the solvency of these banks was questioned causing a freezing of short-term funding markets. Figure 3 illustrates the liquidity shock for European banks plotting the withdrawals from US Money Market Mutual Funds in 2011 from these banks. The Funds withdrew more than $200 billion from European banks in 2011, and particularly the French banks were affected having substantial short-term funding exposure, e.g. through their subsidiaries in Greece.

Figure 3. US market mutual funds withdrawals

By September 2011, the European Banking Authority stress tests subjected banks to ‘haircuts’ on the sovereign-bond holdings, inducing a shift in non-GIIPS banks away from these holdings. However, the GIIPS banks increased their exposure to domestic sovereign debt after December 2011, when the ECB injected about €1 trillion into the banking system. Table 2 also highlights this increase in Italian, Spanish and Portuguese holdings of GIIPS banks between December 2011 and June 2012.

Who invests in carry trades?

The carry trade behaviour described above is consistent with moral hazard behaviour by under-capitalised banks. Acharya and Steffen (2013) show that banks with low Tier-1 capital and high risk-weighted-assets to total asset ratios, were more likely to be invested in these trades for two reasons:

  • Under-capitalised banks had incentives to shift further into risky sovereign debt as the failure of this trade (sovereign default or credit risk deterioration) is precisely when they are also insolvent and they benefit if sovereign bond prices improve, as described in Diamond and Rajan (2011) (i.e. ‘risk shifting’);
  • Basel II regulation that requires banks to meet a capital ratio based on regulatory equity and risk-weighted assets provides banks incentives to shift into assets with lowest risk weights, i.e. sovereign debt.

As sovereign debt had zero capital requirements for all banks (and even those that use the advanced internal ratings-based approach), banks had incentives to shift into these risky assets (‘regulatory capital arbitrage’).

The 2010 stress tests in Europe that relied on Tier-1 to risk-weighted-assets ratios did not address these incentives for banks by continuing to rely on zero risk weights for risky sovereign debt (see also Acharya, Engle and Pierret 2013). Thus, as long as banks had short-term funding available, they continued to purchase GIIPS sovereign debt even as yield spreads already widened in 2010. The ECB funding against sovereign debt, and even its mere anticipation, may have only facilitated and implicitly encouraged this behaviour further.


Government bailouts after the 2008-2009 financial crisis left the European banking sector highly under-capitalised relative to other Western economies such as the US and UK, where banks were re-capitalised and partly nationalised. Not only did the bailouts make the sovereigns riskier as they took on additional debt burdens (Acharya, Drechsler and Schnabl 2013), but leaving the European banking sector under-capitalised in 2008 –2009 led to a persistence in bank holdings, and even active seeking, of risky government bonds. This induced a strong nexus – the ‘doom loop’ – between the financial sector and sovereign credit risks. Substantial bank recapitalisations against sovereign bond losses (some estimates are provided in Acharya, Schoenmaker and Steffen 2011) could be a prudent way to break this nexus: this would restore bank incentives to avoid undertaking carry trades using sovereign bond positions and in turn induce the governments to take measures for improving their access to bond markets.

Editor's note: This column is based on CEPR Discussion Paper 9432, which Vox readers can download for free here.


Acharya V, Drechsler, I and P Schnabl (2013), ‘A Pyrrhic Victory? – Bank Bailouts and Sovereign Credit Risk’, Working Paper, NYU Stern School of Business.

Acharya, V and S Steffen (2013), The “Greatest” Carry Trade Ever? Understanding Eurozone Bank Risks, Working Paper, NYU Stern School of Business.

Acharya V, R Engle and D Pierret (2013), Testing Macroprudential Stress Tests: The Risk of Regulatory Risk Weights, Working Paper, NYU Stern School of Business.

Acharya V, Schoenmaker, D and S Steffen (2011), “How much capital do European banks need? Some estimates”, VoxEU.org, 22 November. 

Angeloni, Chiara and Guntram Wolff (2012), “Sovereign portfolios or banks’ location: What channels sovereign risk into banking systems?”, VoxEU.org, 19 April.

Diamond, D and Rajan, R G (2011), “Fear of Fire Sales and the Credit Freeze”, Quarterly Journal of Economics, 126(2), 557–591.

European Commission (EC) (2010), Commission Decision on State Aid implemented by the Kingdom of Belgium, the French Republic and the Grand Duchy of Luxembourg for Dexia SA, Brussels.

1 In fact, eventually the European Commission explicitly recognised its concerns with respect to the large amount of sovereign debt in Dexia's portfolio and the use of interest rate derivatives which "probably requires significant collateral for Dexia, which may reduce its eligible collateral base for financing from the central banks or in the interbank repo market" (EC 2010).

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