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Banks and government bonds: A love story

European banks have been criticised for holding too much domestic government debt during the recent euro area crisis, intensifying the doom loop between sovereign and bank credit risks. This column deviates from previous research that focused on 'bad' reasons for holding sovereign debt, and points to a 'good' reason: an informational advantage that particular banks have regarding sovereigns. This seems to have had a role in the fragmentation of European government bond markets. 

Can commercial banks act as lightning rods for government bonds in the midst of a financial storm? Is it possible to attribute banks’ home bias in sovereign exposures to something beyond their externally imposed incentives (such as moral suasion) or internally distorted incentives (such as risk-shifting)? Despite the called ‘doom loop’ between the two, could the relationship between banks and their domestic governments have an underexplored silver lining à la Butler (2008)?

These are the questions I pursue in a recent paper (Saka 2019). By using a novel bank-level dataset compiled from various stress tests and transparency and capital exercises by the European Banking Authority (EBA), I first confirm the previous literature by illustrating that the European banks’ home bias in sovereign bonds almost doubled in response to the euro area crisis. Figure 1, constructed using a separate country-level dataset, complements this finding and additionally shows that the phenomenon was unique to financial intermediaries compared with other types of creditors situated in the same set of countries – a clear indication of commercial banks falling in love with the sovereign debt of their own countries. 

Figure 1 The rise and fall of euro area banks’ home bias in government bonds

Source: Saka (2019).

Notes: The figure shows simple country averages of sovereign portion held separately by resident banks and other (non-bank) residents. Sovereign Portion is defined as the portion of the total sovereign debt of a country held by a particular creditor group. Sovereign debt exposures come from the dataset compiled from various national sources by Merler and Pisani-Ferry (2012) and include quarterly observations from 2005-Quarter1 to 2015-Quarter2. Core (non-crisis) countries: Belgium, Finland, France, Germany and Netherlands. Periphery (crisis) countries: Greece, Ireland, Italy, Portugal, Spain.

Bad reasons to fall in love

So far, the literature has mainly attributed the increase in sovereign home bias to the ‘moral suasion’ hypothesis, that is, the possibility that the governments may implicitly force their domestic banks to hold a larger chunk of government bonds when they experience stress (Ongena et al. 2016). Another often-cited hypothesis relates to ‘risk-shifting’, where weakly capitalised banks may voluntarily bet on risky government securities in order to shift the risk from shareholders to creditors (Horvath et al. 2015). A more elusive, but no less important, channel has been pinpointed by Broner et al. (2010) whereby well-functioning secondary markets pave way for the sovereign debt to flow back to the issuing country in times of high stress, since such reallocation would endogenously prevent the sovereign from defaulting on its promises. Finally, carry-trade incentives of the domestic banks might be blamed for the excessive exposures to high-yielding risky sovereigns (Acharya and Steffen 2013).

With the dismal interaction between sovereign and banking crisis in the background, most of this literature has focused on listing the ‘bad’ reasons for the increasing home bias that could amplify the negative loop between banks and governments, and thus endanger the financial stability. In my paper, I provide further evidence that this jump in home bias during the euro area crisis was not unique to sovereign debt category but could be equally – and perhaps even more intensely – observed in retail or corporate types of debt in the very same bank balance-sheets. This finding is unlikely to be explained by the previous studies which treat sovereign debt as a special category and therefore ignore the possibility that the home bias could partly be driven by a more general phenomenon that could simultaneously influence multiple asset types during financial downturns.

A good reason to fall in love: Information 

In a slightly different context, the literature has already shown that local banks stand in a favourable position to have access to soft information regarding their sovereign clients thanks to their “daily exposure to local news stories, first-hand knowledge of the local economy, and personal relationships with key people at the issuing body” (Butler 2008). This effect is found to be especially strong when the issuing government is riskier. Consequently, during market downturns when sovereign risk rises, such informational advantage might lead domestic banks to act as buyers of last resort, absorbing the local assets while (potentially uninformed) foreign banks may shed their exposures in panic. Indeed, a theoretical role for the lack of soft information and the resulting panic by less-informed foreign banks are consistent with the evidence that government bond spreads moved in a self-fulfillingly pessimistic way during the euro area crisis and fell out of touch with the publicly observable hard information on the solvency of individual countries (De Grauwe and Ji 2012, Saka et al. 2015). 

In order to identify the effect of information on government bond holdings of the banks in my sample, I first gather various cross-country informational distance measures commonly used in the international finance/trade literature. These range from financial information proxies that track the bank branch linkages (or historical merger activity) across countries to variables that capture the common linguistic and media trends. However, directly checking the effects of these proxies on banks’ government bond holdings may not be suitable due to the risk of picking up unobserved country- or bank-specific characteristics or, more importantly, other types of bilateral cross-country linkages that may not have anything to do with information. This weakness calls for the second layer of my identification strategy where I benefit from the theoretical prediction that the information channel should be stronger for riskier assets (Portes et al. 2001, Butler 2008). 

Thanks to these two layers, I can employ a difference-in-differences model in which I estimate the interaction of information proxies with a measure of sovereign risk while saturating the model with a full set of fixed effects, especially including dummies at the level of interaction between home country and exposure country so that all time-invariant bilateral cross-country linkages could be directly controlled. This aspect is crucial for my identification strategy and restricts the model to only using the time variation available in sovereign risk to be able to identify the information channel. That is, the interaction of cross-sectional variation in sovereign risk and informational proxies is automatically captured by fixed-effects and, if there is not enough time variation in bond spreads, the inclusion of these dummies would bias my estimates downwards. For example, if British banks typically hold high levels of Cypriot government debt due to their informational advantage in Cyprus, I can capture this only if there is enough variation over time in the Cypriot government bond spreads; otherwise, such pair-specific relationships will all be subsumed by time-invariant cross-country fixed effects.

As a result, I find strong evidence supporting the argument that banks headquartered in informationally closer territories increase their relative exposures as sovereign risk rises. This effect is robust to controlling for alternative mechanisms such as the banks' risk-shifting tendency, the political strength of their home countries, or the exchange rate/redenomination risk. Interestingly, information seems to matter both in the forms of financial (i.e. bank branch linkages) and general (i.e. common language) knowledge regarding the country of exposure. What is even more interesting is that the effects are statistically and economically meaningful even after the end of the euro area crisis (mid-2012). For instance, for the country with median sovereign bond spreads in my sample (144 basis points), a change in branches from 0 to 220 (the mean level) corresponds to an additional sovereign bond holdings of around 5% at the individual bank level. This effect is more than four times larger than the average holding in my sample (1.2%). In comparison, the size of that effect is close to 50% of the additional contribution of the crisis to average home bias that was documented previously.

Information versus the home bias channels

As mentioned above, the recent literature has so far emphasised the ‘bad’ ways of sovereign debt reallocation specifically in the context of sovereign debt home bias. In order to avoid the potential omitted variable problem that may be caused by this home bias phenomenon and its unobserved channels (such as moral suasion or secondary markets), I take a rather extreme approach by dropping all the domestic observations from the full sample and reporting a second set of results only with the banks' remaining exposures to foreign countries. Note that this is a conservative way of identifying the role of information on banks' government bond holdings since such a channel, if it exists, would probably be strongest between governments and domestic banks.  By dropping these domestic observations and comparing the informational closeness only across foreign banks, I would potentially be underestimating the true magnitude of the information channel in exchange for providing a cleaner identification.

In the end, I confirm that my results hold (even more strongly with some proxies such as historical merger activity) when I concentrate only on the banks’ foreign exposures. That is, ceteris paribus, when foreign banks retreated from the sovereign debt markets of the crisis countries in the euro area, they did less so for the countries to which they were informationally closer.

Policy implications

These findings imply that, if the information channel gets activated between governments and domestic banks in the midst of a crisis, this may be considered as a stabilising force compared to a situation where even domestic banks rush out of the market and governments find it impossible to rollover their debt. Therefore, the close link between governments and their domestic banks may create positive externalities in terms of mitigating the effects of sudden stops and preventing the inefficient sovereign defaults. 

Nevertheless, policy discussions have so far emphasised shifting the regulatory power from national to supranational institutions to avoid moral suasion (Acharya 2012) or coming up with various innovations of debt issuance in order to cut off the link between sovereigns and their banks (Brunnermeier et al. 2016). Taken at face value, my results imply that these precautions would not be sufficient to prevent the rising home bias problem – to the extent that it constitutes a problem – during crises. Instead, further policy discussions may also focus on increasing transparency in the sovereign debt markets particularly in times of crisis, or encouraging more cross-border banking activities to improve the informational ties across countries.

An empirical implication of my results is the possibility that the previous literature on the rising sovereign debt home bias in the euro area may have overestimated the role of alternative channels by simply comparing domestic bank exposures to foreign ones in the absence of explicit controls for informational heterogeneity across banks. More research is particularly needed in order to understand the delicate nuances between information and moral suasion when banks and governments are closely linked to each other. 


Acharya, V V (2012), "Banking union in Europe and other reforms",, 16 October.

Acharya, V V, and S Steffen (2013), "The banking crisis as a giant carry trade gone wrong",, 23 May.

Battistini, N, M Pagano, S Simonelli (2014), "Systemic risk, sovereign yields and bank exposures in the euro crisis", Economic Policy 29(78): 203–251.

Broner, F, A Martin, and J Ventura (2010), "Sovereign risk and secondary markets", American Economic Review 100(4): 1523-1555.

Brunnermeier, M, S Langfield, M Pagano, R Reis, S Van Nieuwerburgh, and D Vayanos (2016), "ESBies: Safety in the tranches",, 20 September. 

Butler, A W (2008), "Distance still matters: Evidence from municipal bond underwriting", Review of Financial Studies 21(2): 763-784.

De Grauwe, P, and Y Ji (2012), "Mispricing of sovereign risk and multiple equilibria in the Eurozone",, 23 January.

Horvath, B L, H Huizinga, and V Ioannidou (2015), "European banks’ sovereign debt home bias: Voluntary or involuntary?",, 31 July. 

Merler, S, and J Pisani-Ferry (2012), "Who's afraid of sovereign bonds?", Bruegel Policy Contribution 02/12.

Ongena, S, A Popov, and N Van Horen (2016), "Moral suasion and bond buying in the Eurozone Crisis",, 17 March. 

Portes, R, H Rey, and Y Oh (2001), "Information and capital flows: The determinants of transactions in financial assets", European Economic Review 45(4-6): 783-796. 

Saka, O (2019), "Domestic banks as lightning rods? Home bias during the Eurozone crisis", CESifo Working Paper 7939, forthcoming in Journal of Money, Credit and Banking. 

Saka, O, A-M Fuertes, and E Kalotychou (2015), "How did the ECB save the Eurozone without spending a single euro?",, 26 March.

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