Since the start of the COVID-19 pandemic, European banks have been loading up on sovereign debt and investors have been snapping it up in flight-to-safety behavior—amid the global economy's biggest stress test since the financial crisis. Policymakers have responded decisively to fallout from the COVID-19 pandemic with massive fiscal and monetary policy stimulus to avert the worst and rebuild confidence. In turn, European banks added almost €210 billion in sovereign debt since the start of the year, S&P Global Ratings calculates. Although European sovereigns are issuing large amounts of debt to fund their widened fiscal deficits, yields have dropped on safe-haven bonds, as they tend to do during economic or financial shocks.

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At this point, S&P Global Ratings is not concerned about banks' large uptake in home sovereign debt because we think this trend is temporary and driven by their need to place excess liquidity. Since the outbreak of the virus in March 2020, banks have experienced a strong inflow of household and corporate deposits that showcases the precautionary motives of corporates and rather limited spending possibilities of households during these extraordinary times. More precisely, household and corporate deposits increased by roughly 10% between end-February and end-June in the EU-27 plus the U.K.--that's double the growth rate of roughly 5% during the same period in 2019.

The liquidity from deposits adds to the monetary stimulus from the European Central Bank (ECB) and already elevated liquidity in Europe's banking sector. Even strong loan demand from European corporates on the back of state guarantee schemes and other supportive measures haven't been enough to absorb the cash that banks hold. As a result, banks' treasury departments chose to use the excess cash to invest in highly liquid and risk-free securities (government debt) or to deposit the cash at the central bank to keep their regulatory liquidity coverage ratio high. As a result, EU bank deposits at the ECB surged by roughly €840 billion (close to 40%) between end-February and end-June 2020, a remarkable pace.

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What's more, we think this time is different than in the run-up to the European sovereign debt crisis starting about 2011, sparked by the interconnectedness between sovereigns and banks in some eurozone periphery countries. First, the EU has strengthened its crisis resolution instruments for most member states. It set up the European Stability Mechanism in 2012 to provide a permanent emergency lending facility for member states in need of emergency loans. The recent establishment of the EU Recovery Fund as a provider of grants and loans to EU sovereigns hit hardest by the COVID-19 pandemic is also a strong backstop for troubled sovereigns. Second, over the past several years, strengthening competitiveness, reduced macroeconomic imbalances--supported by the ECB's accommodative monetary stance--have improved eurozone sovereigns' credit standing. The substantial response to the current economic shock by the ECB, including its decision to accept speculative-grade sovereign bonds as collateral for banks' refinancing operations, suggests to us that the monetary union is much better equipped and determined than a decade ago to deal with a widespread economic crisis and to ensure that spreads on sovereign debt don't widen excessively, which ultimately could lead to a sovereign-bank doom loop.

Ample Liquidity Has Pushed Up Home Sovereign Investments

S&P Global Ratings finds that banks' debt holdings of government bonds rebounded with the outbreak of the COVID-19 pandemic in the EU-27 plus the U.K. What's more, holdings of home sovereign debt increased roughly 15% between end-February and June 2020--an increase of almost €210 billion and nearly 7x the rise during the same period in 2019. Overall, banking systems in Europe continue to carry an elevated amount of home sovereign exposures of nearly €1.600 trillion at end-June 2020 (roughly 10% of the GDP of the EU-27 plus U.K.). This compares to roughly €600 billion of government bond investments in the EU-27 plus U.K. outside the home country of banks (foreign sovereign debt). Bank purchases of foreign sovereign debt have increased nearly €100 billion since the outbreak of the virus. The tight link between banks and home sovereigns is a recurrent source of policymaker contention because it operates in the opposite direction of the much discussed but still-unresolved initiative to create a pan-European deposit issuance scheme, the third pillar of the banking union. This would work to spread risk throughout the European Monetary Union, rather than concentrate it in individual member countries.

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There Are Incentives To Loading Up On Sovereign Debt

The main reasons for the current and historical increases in sovereign debt holdings by banks, we believe, are a massive monetary stimulus by central banks to respond to the repercussions from COVID-19, regulatory capital rules that still allow banks to typically hold little to no capital to cover credit risk from lending in local currency to their home sovereigns, and other reasons like liquidity rules, collateral posting and hedging costs.

• The ECB has introduced a number of measures to support banks in general and has indirectly fed the increase by providing banks with cheap funding, with its long-term refinancing and targeted long-term refinancing operations introduced in the last decade and recently enlarged. While such operations calmed the markets, banks also used these operations to borrow at cheap rates from the ECB, then turned around the money to buy government bonds that yield more than their borrowing cost, so-called carry trades--that resulted in easy profits. (See the next section for chart 4 and a full discussion of the ECB's measures.)
• Existing regulatory rules give national authorities (or regional jurisdictions in the case of the EU) the discretion to allow their supervised banks a zero-percent risk weight for sovereign exposures denominated and funded in the domestic currency.
• Basel III's liquidity coverage ratio requires banks to hold a reserve of high-quality liquid assets as a liquidity buffer and allows them to invest in sovereign debt without limit and not typically subject to a haircut to their market value.
• Because of their status as risk-free assets and lower haircuts due to their high liquidity, sovereign bonds continue to be heavily used by banks for collateral posting in the interbank market for secured funding.
• To avoid foreign exchange risk or the cost of hedges, banks outside the eurozone prefer to invest in home sovereigns and subsovereigns. This is especially the case for countries in Central and Eastern Europe (CEE) without the euro as currency like Hungary, Romania, and Poland.

Banks Are Using Added Liquidity To Buy Government Bonds And Park Cash

The ECB has undertaken a number of measures, aimed at banks, to help the EU economy deal with economic shocks from COVID-19 (see chart 4). Temporary capital and liquidity relief measures, which ECB's banking supervision (Single Supervisory Mechanism) announced in March 2020, have also contributed to banks' capacity to lend to the private sector. While our analysis takes us to June 2020, we believe the central bank's policies are unintentionally acting as an incentive for banks to add to their sovereign debt holdings, which time will tell. What's more, the ECB may take additional accommodative measures that might accelerate this trend. Banks could use further cheap funding sources from the ECB and invest them in higher-yielding bonds with moderate risks to make profits. Still, we don't expect this situation to become permanent. It will likely unwind once the recovery kicks in and the private sectors returns to business as usual.

The ECB's extraordinary monetary policy measures taken in first-half 2020 fall into two broad categories: asset purchases to stabilize financial conditions and liquidity support for eurozone banks to provide loans to the real economy. With the introduction of the Pandemic Emergency Purchase Programme (PEPP) and the scaling-up of purchases under its existing Asset Purchase Programme (APP) in March 2020, the ECB managed to stop a tightening of financial conditions in several securities markets. The PEPP started with an envelope of €750 billion that was soon increased to €1.350 trillion in June 2020 as the economic and inflation outlook deteriorated.

Furthermore, the ECB launched its Pandemic Emergency Longer-Term Refinancing Operations (PELTROs) in April 2020 to ensure sufficient liquidity for banks to fund the real economy. Participating banks benefit from favorable interest rate conditions and softer collateral requirements. This works in tandem with the recalibration of the ECB's existing Targeted Longer-Term Refinancing Operations III (TLTROs III) since March 2020, for which the policymakers increased the maximum loan amount that banks are entitled to borrow while loosening borrowing conditions.

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In our view, the ECB measures were crucial in averting the worst for Europe's financial markets and providing sufficient funding to the private sector--via banks as intermediaries. That said, we think a large part of the four programs above--PEPP, APP, PELTROs, and TLTROs III--were also channeled into government bonds. While bank lending to the private nonfinancial sector increased by €270 billion in the eurozone between February and June 2020, banks' investments in home sovereign debt surged by a still sizable €185 billion during the same period. To put that into context, European banks hold much more private-sector debt than public-sector debt, €17 trillion versus €1.6 billion, respectively, at end-June 2020, which should be taken into account when looking at growth rates.

We think banks used a relatively big chunk of the liquidity injection from PELTRO and TLTRO III lines to temporarily buy government bonds as a way to park cash as a precaution for gloomy times and shore up their balance sheets. During economic downturns, assuming banks have access to cheap funding, sovereign debt may also deliver more favorable risk-adjusted returns than private lending due to lower credit losses. What's more, banks tended to anticipate the ECB's decision to enlarge the PEPP at the beginning of second-quarter 2020, which happened at the end of the quarter, bringing additional returns to their bond portfolios because of the positive valuation effect.

Finally, a number of European governments have created loan guarantee schemes this year with the aim of absorbing potential loan losses from defaults in the private sector. These guarantees are an important backstop for banks, especially for loans to companies in the hardest-hit sectors. However, such measures increase the interconnectedness between banks' and sovereigns' balance sheets, in that banks would be able to transfer such losses to the sovereign. These contingent liabilities--obligations that have the potential to become government debt if and when they materialize--will become more important in assessing the extent of the sovereign-bank nexus.

Banks On The European Periphery And CEE Still Have The Highest Home Sovereign Exposures

Despite European governments' efforts to increase risk sharing of the fiscal cost of the pandemic, we have seen few signs of this on the part of European banks. In contrast, they have concentrated more risk to their home country by buying more home country sovereign debt, especially in countries with the highest share, increasing the risks of a new doom loop if this trend persists, in our view.

The share of home sovereign debt that domestic banks hold varies greatly from country to country in Europe. In countries like Germany and France, it's typically just about 5% and 10% of total private-sector lending. For many other economies, like Spain and Portugal, the ratio is closer to 20%. Banks in the largest countries in CEE hold the highest amount of home sovereign bonds with a ratio close to 50%. We note the base effect for some countries, particularly where private-sector debt sharply declined in the past decade (like Spain, Portugal, Greece, and Ireland). That said, sovereign bonds still comprise a large share of bank's total assets in these countries. Looking at the last five years, banks in peripheral Europe and CEE continue to have strongest home sovereign bias in Europe ("Undoing The Doom Loop: A Look At The Links Between European Banks And Sovereign Debt," published on June 21, 2016).

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We think this is an area of attention, particularly for CEE and EU periphery countries, where banks' exposures were already elevated before COVID-19. That's because the correlation between sovereign distress and a country's financial sector distress is high and positive. Although it's a fairly remote scenario at this stage in Europe, in case of sovereign distress and higher credit spreads for government bonds, banks would have to devalue their sovereign debt security holdings (treasury bills and loans), causing asset losses and weakening capital adequacy. From the perspective of sovereigns, banks play a fundamental role in financing and facilitating the real economy that is the engine of wealth and growth. This is even more so for countries where capital markets are relatively underdeveloped and illiquid (such as in the CEE), making debt security issuance costlier than direct loan borrowings.

Stress of either the sovereign or the banking system would therefore affect the other--triggering a doom loop. This happened in 2012, when Greece restructured and exchanged its debt, to the detriment of investors, including banks in the country.

The EU Recovery Fund Offers An Alternative To National Debt

One development that is a step toward weakening the doom loop is the creation of the EU Recovery Fund in late July. The fund is large (at €750 billion, equivalent to just under 5% of the region's GDP), and redistributive. A key feature is that the supranational body, the EU, will depart from its previous policy of not financing deficits and borrow on commercial markets to finance upfront transfers. By issuing debt in the market on this scale, the EU also provides the ECB, as well as European commercial banks, with a new liquid euro-denominated benchmark instrument that is an alternative to national debt. We expect that some investors will rotate out of national bonds into the newly formed EU debt. However, this is unlikely to happen for higher-yielding government bonds of countries on the EU periphery.

During the initial stage of the COVID-19 pandemic, EU sovereigns principally took a unilateral national fiscal approach to addressing the fallout on their economies, including on public-sector entities. However, not all member states were able to provide the same level of direct fiscal support, which ranged from around 1% of GDP in Portugal to 9% in Germany. With the creation of the Recovery Fund, the EU has invested in a shared fiscal response, which is a key step toward becoming a fiscal union, in our view.

We believe the political consensus for establishing the fund, and endowing it with debt-raising capacity, is a major step forward for the EU and will support Europe's long-term economic and financial stability. It complements other fiscal facilities the EU has already put in place to deal with the fiscal fallout from COVID-19, including the €100 billion SURE fund (which contributes to the cost of employment subsidies), and the ESM Pandemic Crisis Support Credit Line (equivalent to 2% of member states' GDP, to support national health budgets).

A Regulatory Solution To The Doom Loop Is Some Distance Away

The Basel Committee on Banking Supervision (BCBS) has been considering proposals to tighten the regulatory treatment of banks' sovereign exposures, which it currently considers as risk-free. We do not consider them as risk free and apply risk weights in our measurement of capital—our risk-adjusted capital (RAC) ratio. While we believe the proposals go in the right direction, some don't go far enough, in our view. Roughly 40 parties responded to the BCBS' December 2017 discussion paper on this topic, including S&P Global Ratings ("Basel Paper On Banks' Sovereign Exposures: Not Enough To Undo The Doom Loop," published March 8, 2018).

Table 1

We believe the additional Basel III Pillar 2 guidance and Pillar 3 disclosure requirements are steps in the right direction. However, we still think the proposed Pillar 1 measures, namely an overly soft introduction of positive risk weights for domestic sovereign exposures and light marginal risk weight add-ons for single-country concentrations, are not sufficient to undo the doom loop.

Table 2

Since it published the request for comment in December 2017, the BCBS has asked for another round of feedback about its proposal to require banks to make three additional disclosures--more information about their sovereign exposures and risk-weighted assets by jurisdictional breakdown, currency breakdown, and accounting classification.

We understand there is no update about the Pillar 1 and Pillar 2 proposals. We note the ECB's push to bring more money into banking systems, which sustain government borrowing. In light of regulators' aim to offer some relief from minimum capital requirements and buffer due to the COVID-19 shock, we do not expect an update from the BCBS in the near future. Its recent decision to delay the implementation of the latest revision to Basel III capital rules (Basel IV) by one year indicates that a definitive solution to these issues is some distance away.

Ignoring Sovereign Risks Could Unleash A New Doom Loop

Banks in Europe, and around the world, have played a vital role in financing corporates and households during the COVID-19 crisis. This is also true for some of the governments' fiscal support measures that banks have funded by increasing their investments in sovereign bonds. S&P Global Rating's view is that the surge in home government bond investment in Europe is a temporary response to excess market liquidity. If this turns out not to be true and the trend persists, overlooking sovereign risks could unleash a new doom loop in the distant future, particularly where banks have built up extremely large exposures to sovereign debt. This is now even more important in light of the large-scale loan guarantee schemes that are tightening the sovereign-bank nexus and increasing contingent liability risks across Europe.

Related Research

• What The EU Recovery Fund Breakthrough Could Mean For Eurozone Sovereign Ratings, July 22, 2020
• How COVID-19 Is Affecting Bank Ratings: June 2020 Update, June 11, 2020
• Basel Paper On Banks' Sovereign Exposures: Not Enough To Undo The Doom Loop, March 8, 2018
• Undoing The Doom Loop: A Look At The Links Between European Banks And Sovereign Debt, June 21, 2016
• Unraveling The Credit Links Between Western European Sovereigns And Banks Is Still A Work In Progress, July 9, 2015