Corona crisis: The sovereign-bank nexus is tightening

In March, euro area banks began to strongly raise their domestic sovereign exposure, which consists of both debt securities and loans. This marks the end of a trend of falling or stable claims which had prevailed since 2015. Banks boosted their exposure by EUR 61 bn in March, EUR 82 bn in April and EUR 52 bn in May, which adds up to the strongest growth in three consecutive months ever recorded. At the end of May, the total outstanding reached EUR 2,173 bn. During the same period, banks also expanded their claims on other euro area sovereigns by EUR 67 bn to EUR 580 bn (+13%, vs +10% for domestic exposures). This, in relative terms, even greater gain slightly diminished the home bias - the ratio of banks' domestic to all euro area sovereign exposure - to 79%.

Claims on the domestic sovereign also rose in relative terms. In relation to total assets, they grew by 30 bp to 6.4% despite a considerable increase in assets to EUR 35.2 trillion at the end of May. Banks accommodated surging credit demand from companies and also strengthened their own liquidity buffers at the central bank. Capital and reserves, by contrast, remained almost unchanged which pushed up the ratio of domestic sovereign exposure to equity from 78% at the end of February to 86% at the end of May. Banks' exposure to all euro area sovereigns climbed to 7.8% of total assets and 109% of equity.

A look at the national banking markets reveals sizable differences within the euro area, even though all banking systems (except for the Dutch) increased their domestic sovereign exposure in absolute and relative terms. Among the five largest countries, banks in Italy and Spain recorded the strongest increase and the highest share of domestic sovereign exposure. In France and Germany, the share is below the euro area average. Dutch banks are financially the least exposed to the domestic government.

The overall increase in sovereign exposure was mainly driven by exceptionally large purchases of debt securities, while there was no comparable surge in loans to the public sector. This suggests that banks mostly financed central governments, as state-level authorities rely less heavily on securities and local governments mostly use loans to cover funding needs. National governments jump-started expansionary fiscal programmes in March in order to mitigate the economic slump caused by the corona lockdown. At the same time, the net issuance of debt securities by governments ballooned. In March, it was EUR 84 bn, twice the long-term average. In April, it skyrocketed to EUR 172 bn. Hence, banks are funding a sizable share of the fiscal expansion.

Banks could be investing in euro area sovereign debt for safety reasons given the economic downturn. Moreover, banks may be buying government debt to turn it in for liquidity at the ECB. But bonds from peripheral countries had also become more attractive due to rising yields. Obviously, given ECB funding at zero or negative rates, the carry trade from such investments helps banks to generate much needed interest income. Whatever the reason, the sovereign-bank nexus in the euro area is currently tightening again.

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