Italian and French banks revive fears of ‘cycle of destruction’ with bond purchases

Italian and French banks revive fears of ‘cycle of destruction’ with bond purchases

“The increase in liabilities going between banks and governments is worrying to me and policymakers should look to address it,” said Nicolas Véron, a senior fellow at the Bruegel think-tank in Brussels. “But the risk seems a bit beyond the horizon that keeps policymakers awake nowadays.” The region’s sovereign-bank connection is back on the agenda in Brussels as the European Commission is conducting a public consultation to examine potential reforms of the EU’s financial crisis management tools and bank deposit insurance framework.  Eurozone governments have issued a record amount of bonds in the past year to fund their pandemic response, sending indebtedness in the bloc above 100 per cent of gross domestic product for the first time.

At that time, banks’ vast domestic sovereign debt exposure created a “doom loop”, as a vicious circle between private sector lenders and governments weakened each other and ultimately threatened the existence of the single currency zone. The strengthening of ties binding banks to their national governments has reawakened concerns over a faultline in Europe’s monetary union that was exposed during the region’s sovereign debt crisis a decade ago.

“Sovereign risk on bank balance sheets has still not been tackled, in contrast to other risk mitigation measures introduced by the banking union,” said Heike Mai, banks analyst at Deutsche Bank. “It remains the elephant in the room. The current pandemic with its surge in public debt highlights the need for reform.” The exposure of Italian banks to domestic government debt hit a record €712bn last August, up more than 9 per cent from February and dipping only slightly since then. French banks had the sharpest post-pandemic rise in their exposure to their own government, which climbed to a record €431bn in September, a jump of more than 18 per cent since February.

Lorenzo Bini Smaghi, chair of French bank Société Générale, said regulators may be incentivising lenders to buy government bonds by allowing only those with high capital levels to restart dividend payments. “Banks may want to invest mainly in safe assets to protect capital levels in view of the message coming from regulators,” he added. While eurozone banks’ exposure to their own governments’ debt had been declining since Greece’s final international bailout in 2015, it started to rise again after the pandemic hit a year ago — particularly at Italian and French lenders. Banking regulations treat sovereign debt as a risk-free investment for banks, allowing them to allocate zero capital against such assets. By borrowing money from the ECB as cheaply as minus 1 per cent, there is an easy “carry trade” for banks to make money from buying government bonds.

“Banks have to respond to the issuance of bonds by the state because they feel it is a good investment to hold in terms of risk and they are encouraged to do so to maintain liquidity,” said Jacques de Larosière, a former head of the IMF and Banque de France. But huge bond-buying by the European Central Bank has driven down borrowing costs for eurozone governments close to all-time lows, combined with the EU’s agreement on a recovery fund to provide €750bn of grants and loans to the hardest-hit countries. 

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