There is a ‘good’ reason for EU banks to hold their own country’s sovereign debt

Commercial banks have an informational advantage that allows them to act as buyers of last resort, absorbing local assets while potentially uninformed foreign banks may shed their exposure, writes Orkun Saka

Is it possible to attribute the banks’ home bias in sovereign exposure to something beyond their externally-imposed (such as moral suasion) or internally-distorted (such as risk-shifting) incentives? Despite the so-called doom loop between the two, could the relationship of banks with their domestic governments have an underexplored silver lining?

These are the questions I pursue in a recent paper. By using a novel bank-level dataset compiled from various stress tests, transparency and capital exercises of 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 Eurozone crisis. Figure 1, constructed with a separate country-level dataset, visually complements this finding and additionally shows that this 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.

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