VoxEU Column Financial Regulation and Banking

Preferential regulatory treatment and banks’ demand for government bonds

Economists continue to debate whether preferential treatment in financial regulation increases banks’ demand for government bonds. This column looks at bank purchases of government bonds and other types of bonds when constrained by a capital or liquidity requirement. Financial regulation seems to be a main driver of banks’ demand. If regulators wish to break the vicious circle from weak banks to weak governments, revising financial regulation seems to be a good starting point.

Many banks around the globe hold sizeable shares of government debt securities. Some argue that the 0% risk weight in the context of capital regulation is a key driver of banks’ holdings of government bonds. Besides capital regulation, government debt securities also receive preferential treatment in the newly proposed Basel III liquidity requirements, as well as in the context of regulatory efforts to limit large exposures to individual countries and counterparts. Apart from financial regulation, there are three hypotheses that are commonly referred to when trying to explain banks’ government bond holdings:

  • Banks hold government bonds as a reliable source of liquidity and collateral (Gennaioli et al. 2014);
  • Banks hold lower quality government bonds, allowing them to gain from preferential regulatory treatment but at the same time secure high returns (Acharya and Steffen 2013); and
  • Banks hold domestic government bonds to increase the likelihood of public support (Farhi and Tirole 2014).

Bonner (2015) focuses on the question of whether financial regulation increases banks’ demand for government bonds (henceforth the “regulatory effect”) or rather whether banks’ government bond holdings are driven by other factors (henceforth the “internal effect”).

What is the issue?

To understand why financial regulation might increase banks’ government bond holdings, it is useful to begin with a closer look at the calculation of regulatory capital and liquidity requirements. Capital regulation typically requires institutions to hold a specific amount of capital compared to their risk-weighted assets. Risk-weighted assets are determined by multiplying the notional amounts of an institution’s assets by their respective risk weights. Thus, if an institution holds an asset with a 20% risk weight, it needs to hold capital amounting to at least 8% (the current Basel minimum capital ratio) of the notional amount of the respective asset multiplied by 20%. Due to their 0% risk weight, foreign government bonds rated AAA to AA- or any domestic government bond do not require banks to hold any capital, making government bonds relatively more attractive. To increase its capital ratio, a bank can therefore either raise capital or reduce its risk-weighted assets. While banks are able to raise capital in the short run, adjustment costs usually make them hesitant to do so. To reduce their risk-weighted assets, banks can either reduce lending or sell securities. However, since the majority of bank loans have long maturities, compressing the loan portfolio is often difficult. As institutions need sufficient securities for funding purposes, only selling only large amounts of securities with high risk weights is not realistic either. As such, the seemingly easiest way to address a (temporary) capital shortcoming is to substitute bonds with high risk weights by government bonds.

Turning to liquidity regulation, we can see similar dynamics. As a proxy for the Basel III Liquidity Coverage Ratio, I use the Dutch liquidity requirement, which was introduced in July 2003 and revised in May 2011. The Liquidity Coverage Ratio I and the Dutch liquidity requirement are very similar in their design and are both based on classic liquidity ‘coverage’ considerations. Both ratios require banks to hold an amount of high quality liquid assets to cover their net cash outflows over a 30-day stress scenario. Similar to capital, an institution can steer its Dutch liquidity requirement by either increasing its liquid assets or by reducing its outflows. Again, however, reducing liabilities seems to be a less feasible option than increasing liquid assets. Buying government bonds appears to be a relatively efficient strategy to correct a Dutch liquidity requirement deficiency.

Current discussions

While the issue has been discussed on several occasions, especially the emergence of the European sovereign debt crisis raised concerns regarding the vicious circle between weak bank balance sheets and sovereign fragility. A possible way to break this vicious circle is to reduce the regulatory attractiveness of government bonds. In line with this, the Basel Committee on Banking Supervision stated in a recent report to the G20 leaders that it will review the current regulatory treatment of sovereign risk and consider possible policy options (BCBS 2015). Similarly, the European Political Strategy Center of the European Commission recently stated that the sovereign bank link remains a significant problem that has not been addressed by banking legislation. To arrive at sound solutions, however, it first needs to be understood whether financial regulation is truly a key driver of banks’ government bond holdings.

Data and analysis

The correlation between banks’ funding and liquidity needs (or other incentives) and their compliance with regulatory requirements poses a challenge to establishing a causal link from the various incentives for banks to hold government bonds and their actual holdings. To distinguish whether a change in banks’ government bond holdings is caused by regulation or by other factors, one would need detailed information on banks’ targets used in their internal risk management frameworks.

Since such data are not available in a structural form, an alternative approach is to distinguish whether the proximity of a bank to its regulatory liquidity and capital threshold changes its demand for government bonds during the entire following month, or only around the monthly reporting date. The hypothesis is that if banks’ regulatory capital and liquidity position changes their demand for government bonds over the entire next month, it cannot be established whether this is caused by internal or regulatory effects. However, a change in demand only around the reporting date would point towards the presence of a regulatory effect.

Using unique transaction-level data obtained from the Markets in Financial Instruments Directive database for 17 banks from June 2009 to December 2012, I attempt to distinguish regulatory from internal effects and aim to answer the question whether microprudential capital and liquidity regulation increases banks’ demand for government bonds, leading banks to substitute other types of bonds with government bonds. Due to the presence of long-running liquidity and capital requirements in the Netherlands, it is possible to assess the impact of both requirements, allowing to draw the link to Basel III.

My results show that banks constrained by liquidity or capital requirements purchase significantly more government bonds towards the end of the month than banks not constrained by regulation. The relative preferential treatment seems to cause a substitution effect, with banks buying more government bonds while selling more bonds of other types. I also find evidence that this regulatory effect reduces banks’ lending to the real economy.

Policy implications and conclusions

When drawing policy implications, it is important to note that I only discuss whether financial regulation increases banks’ demand for government bonds and whether this effect has an adverse impact on the real economy. While the paper provides new insights into these dynamics, it does not comprehensively answer the question of whether increased government bond holdings are desirable. However, the analysis confirms that if policymakers wish to break the vicious circle between weak governments and weak banks, financial regulation appears to be a good starting point.


Acharya, V and S Steffen (2013), “The greatest carry trade ever? Understanding Eurozone bank risks”, Journal of Financial Economics, forthcoming.

BCBS (2015), “Finalising post-crisis reforms: an update (A report to G20 Leaders)”, Basel Committee on Banking Supervision.

Bonner, C (2015), “Preferential regulatory treatment and banks’ demand for government bonds”, Journal of Money, Credit and Banking, forthcoming.

European Political Strategy Center, “Further Risk Reduction in the Banking Union”, available at http://ec.europa.eu/epsc/publications/series/5p_bankexposure_en.htm.

Farhi, E and J Tirole (2014), “Deadly embrace: Sovereign and financial balance sheets doom loops”, mimeo.

Gennaioli, N, A Martin, and S Rossi (2014), “Sovereign default, domestic banks, and financial institutions”, Journal of Finance 69: 819–866.

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