Politics May Have Helped Create Europe's Sovereign-Bank Loop of Doom
"Correlation does not imply causation, but it does waggle its eyebrows suggestively and gesture furtively while mouthing 'look over there,'" quipped the comic xkcd.
A new working paper by Filippo De Marco and Marco Macchiavelli is likely to raise many eyebrows as it makes the case that political suasion may have created the very thing that helped plunge the eurozone into crisis, using stress test data to argue that higher state ownership and the presence of politicians on bank boards are linked to lenders' penchant for snapping up domestic government debt.
The tendency of European banks to accumulate government bonds issued by their own countries on their balance sheets — banks' average 'home' exposure was a whopping 74 percent of total government debt holdings on the eve of the crisis in late 2010 — created the perfect path for sovereign stress to infect the financial system (and vice versa).
The origins of this so-called sovereign-bank loop, or nexus, have since been the topic of much speculation with blame placed on everything from financial regulation that encourages banks to snap up government debt to the liquidity operations of the European Central Bank (ECB). Even five years on from the worst of the eurozone debt crisis, the debate is very much alive given current proposals to restrict the amount of government bonds on European bank balance sheets and in light of concerns over Italian financials, where domestic state debt accounts for a greater-than-eurozone-average proportion of lenders' total assets.
The paper by De Marco and Macchiavelli, assistant professor of finance at Bocconi University and Federal Reserve Board economist respectively, mounts an altogether more punchy argument, asserting that European banks' accumulation of domestic debt is decisively linked to political influence.
"Politics is at the root of the problem," they write in the paper. "Many European banks are government–owned or have politicians sitting on the board of directors. These politicians may persuade the politically connected banks to finance national or local state borrowing by purchasing domestic government bonds."
Banks owned by the domestic government or with former politicians on their board of directors appear to hold an outsized amount of their own country's sovereign debt, the authors find, with a 1 percentage point increase in the share of politically-linked directors on a bank's board associated with a jump in the ratio of domestic debt exposure versus total exposure of around 1 percent between 2010 and 2013, for instance.
The increase in home bias from the eurozone crisis and onwards has been particularly marked in Southern European countries compared with those in the North. Many cooperative and savings banks in the periphery have a simple business model — take in retail deposits and buy government bonds — that might naturally encourage such activity while coinciding with higher political involvement.
"Not surprisingly, we find that the moral suasion channel is stronger among government-owned banks from the [peripheral eurozone] countries, as weak governments presumably have greater need to use the domestic banks to finance borrowing," the authors write.
Others have argued that such banks may be incentivized to snap up home sovereign debt in what is effectively a gamble on survival — after all, if the sovereign goes bust, then weaker banks are likely to follow suit. The ECB's provision of low-cost funding is also said to have encouraged banks, particularly in the European periphery, to have used the cheap financing to snap up higher-yielding government debt in a carry trade. Meanwhile, Basel banking rules that consider government debt to be essentially risk-free mean that banks seeking to build up capital in times of stress may be incentivized to buy sovereign bonds to boost their ratios as well as profit margins. (In fact, buying periphery bonds in the depths of the eurozone crisis ended up being profitable for many periphery banks). However, even controlling for capital levels and sovereign yields, the link with political influence remains, according to the the authors.
"In the international finance and asset pricing literature, home bias is often explained as the result of informational asymmetries; more recently, home bias in the [peripheral] countries during the sovereign debt crisis has been motivated by creditor discrimination theories. Others claim that financial repression and risk synchronization are the optimal choice of either the domestic government or the individual bank. We do not challenge these hypotheses," the authors conclude. "On the contrary, we complement them by showing that also political pressure on controlled banks plays a crucial role in explaining the rise in home bias at the bank level."
While the paper is unlikely to end the debate over the motives of European banks buying up home bonds, it does suggest that efforts to break the sovereign-bank loop are likely to prove a political hot potato as much as a financial stability one. If the study is right, the recent supervisory exercise to assess banking systemic risk and proposals to break sovereign feedback loop are fraught with even more political risks than assumed.