Banks’ Home-Bias in Government Bond Holdings: Will Banks in Low-Rated Countries Invest in European Safe Bonds (ESBies)?

Abstract

The bank literature has documented theoretical and empirical evidence of a “diabolic loop” in the sovereign-bank nexus. Banks have a concentrated risk exposure in domestic government bonds. In the European banking union, this has led to a proposal to create European safe bonds (ESBies). Securitized sovereign bond-backed securities would facilitate geographical sovereign diversification, hence contributing to bank stability. But will banks in low-rated countries invest in safe bonds?

This paper offers two new explanations for the home bias in government bond holdings: a sovereign-based rating cap on corporates and the existence of a ‘bank tax’. These are complementary to the four explanations offered in the literature: risk shifting, gambling for resurrection, moral suasion, and a way to store liquidity for financing future investment. Collectively they cast doubt on a demand-led approach to investment in safe bonds by banks in low-rated countries. Bank regulations such as constraints on large exposure or risk-based capital on credit risk concentration will be needed if the objective is to break the so-called “deadly embrace”.