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Stop hand-wringing about the sovereign doom loop

The coronavirus pandemic has sparked an unprecedented wave of sovereign borrowing. Much of the paper has, unsurprisingly, ended up on the balance sheets of domestic banks. This has, equally unsurprisingly, prompted a fresh round of worry about the strengthening of the sovereign-bank nexus.

S&P have published a new report pointing out the extent to which banks, particularly in the eurozone periphery and CEE, are increasingly exposed to the debt of their home sovereign. 

The increase is in part thanks to TLTRO, which has made govvies a superb carry trade for banks — not the intended use of the liquidity, but TLTRO funding will mature and that carry trade opportunity will vanish in time and banks' govvie holdings will decline.

Even without TLTRO, though, banks are hugely exposed to their sovereigns. That it is a vulnerability is undeniable. Any concentration of assets in systemically important institutions is a vulnerability.

But what is the alternative? Accounting penalties for banks that hold too much of their domestic sovereign paper is the most common proposal. To what end? Either banks eat the penalties or they divest their holdings.

In the former case, the vulnerability is scarcely reduced, but the scarce resource of European bank profitability is. In the (more likely) latter case, funding costs for their sovereigns are driven up and banks are forced to put their cash somewhere else. Are they less vulnerable? Well, perhaps, but only if the assets they have purchased in lieu of their own sovereign’s paper are comparably secure and yet somehow uncorrelated with their sovereign’s performance.  

The truth is that banks will sink or swim according to the fortunes of their sovereign. If they can’t hold the paper, who can?