Weak economic growth and potential differences in the speed and magnitude of monetary and fiscal policies in the EU mean that the sovereign-bank nexus–-the complex relationship between banks and their home sovereigns–-could re-emerge into the market spotlight next year. S&P Global Ratings considers that the recent decline in EU banks' exposures to their home sovereigns largely resulted from cyclical factors, mainly central banks' now discontinued sovereign bond purchase programs, that are unlikely to persist. We therefore expect EU banks will revert to increasing their sovereign debt holdings from the already sizable level of about €2.3 trillion, which represents 5% of EU banks' aggregate total assets, as of July 2023. Other drivers of the increase include the expected rise in the supply of sovereign bonds to finance fiscal deficits and investments in the green and digital transitions, and structural regulatory and risk management incentives for banks to hold debt instruments from their home sovereigns.

Over the longer term, we believe the sovereign-bank nexus in the EU is here to stay. We see it as a key feature of the European economic system, in which governments play a crucial role, and the European financial system, where banks remain the primary source of funding and where the number of genuinely pan-European banks is limited. While the sovereign-bank nexus can provide stability, for example if sovereigns step in to absorb external shocks, it can also accelerate financial and economic crises because of the strong interconnectedness between banks and sovereigns. The mini-budget that the U.K. government delivered in September 2022, for example, demonstrated how the mismanagement of economic policies can lead to the sudden loss of investor confidence in a sovereign bond market, exacerbated by forced selling due to collateral requirements.

The biggest long-term problem of the sovereign-bank nexus is the obstacle it presents to the completion of the Banking Union, in particular to the creation of a European Deposit Insurance Scheme (EDIS). Indeed, some EU policymakers consider that an EDIS would spread the risk of bank failures across the entire EU, rather than containing it within individual member countries. Therefore, these policymakers' precondition is a reduction of the sovereign-bank nexus since otherwise an EDIS would lead to a mutualization of sovereign risks across the EU--a political red line for some EU member states. The lack of banking and financial market integration is one of the key obstacles to banks' broader competitiveness because fragmented national markets lack the benefits of economies of scale.

The Sovereign-Bank Nexus Is Here To Stay, For Better Or Worse

The sovereign-bank nexus describes the complex, intertwined relationship between banks and their home sovereigns, in this case in the EU (see chart 1). This relationship is characterized by four main aspects:

• EU banks have significant direct exposures to their home sovereigns' debt, which represented approximately €2.3 trillion as of July 2023 and accounted for about 5% of banks' aggregate total assets. The share of banks' home sovereign debt holdings relative to their total assets differs significantly across the EU, with banks in central and eastern Europe displaying the highest relative exposures.
• EU banks' funding conditions are closely linked to their home sovereigns. Consequently, widening sovereign credit spreads are a key risk for banks' capacity to access capital markets at economical costs.
• Most EU banks mainly operate within the boundaries of their home markets. This makes them vulnerable to their home sovereigns' economic policies, which significantly influence economic growth and employment levels and therefore banks' business and asset quality prospects. That is why our ratings on EU banks do not exceed the level of the rating on the home sovereign for all but two rated EU banks (see table 1).
• Conversely, sovereigns are exposed to their domestic banking systems, either directly in the form of contingent liabilities--the cost they would have to pay in the case of bank failures--or indirectly when dealing with the economic hardship of a banking crisis.

Chart 1

During periods of economic rather than market stress, the sovereign-bank nexus can be a source of strength for banks and sovereigns alike. Among the most recent examples are the guarantees that were part of governments' COVID-19 support packages and had a clear positive effect on banks' asset quality. That very interconnectedness between banks and sovereigns, however, can also exacerbate financial and economic crises. Problems in the banking sector can have devastating ripple effects on sovereigns, and vice versa-–the so-called sovereign doom loop (see chart 2). To avoid this negative feedback loop, authorities instructed EU banks to clean up their balance sheets and introduced the Banking Union's first two pillars, namely common supervision and resolution. Even so, banks' direct and indirect exposures to their home sovereigns are still high, while sovereigns, to a large extent, continue to rely on banks for financing purposes.

Chart 2

EU Banks' Sovereign Exposures Declined Moderately

As of July 2023, eurozone banks held a sizable amount of sovereign debt that amounted to €2.5 trillion and included loans (€1.56 trillion) and debt securities (€0.98 trillion) from eurozone countries. About 80% of this debt, equivalent to €2.0 trillion, was issued by the banks' home sovereigns (see chart 3) and constituted 5% of their aggregate total assets.

The situation remains similar when broadening the analysis to banks in all 27 EU member states. Home bias is a persistent phenomenon in the banking sector. The collective stock of home sovereign exposures on EU banks' aggregate balance sheets amounted to €2.3 trillion as of July 2023.

Chart 3

EU banks' sovereign exposures have reduced gradually to 5.3% of aggregate total assets--or 75% of banks' aggregate balance sheet equity--as of July 2023, down from the peak of 7.8% of total assets in October 2014 (see chart 4). It's worth noting that the data includes state banks or government-owned banks with public policy objectives. These banks tend to carry higher sovereign exposures on their balance sheets than commercial banks. When considering commercial banks across Europe, we rely on consolidated data sourced from the European Banking Authority (EBA).

Chart 4

In our view, EU banks' gradual decline in sovereign exposures mainly results from cyclical changes on the government bond market, with central banks playing an increasingly important role as buyers of government debt in the context of their quantitative easing programs. Over the last decade, the amount of government debt in the eurozone increased by 540% to about €3.7 billion in June 2023. Consequently, government debt held by Eurosystem central banks increased to about 30% of total government debt in the eurozone.

Sovereign exposures differ across geographies

With over 10% of their consolidated assets, banks in central, southern, and eastern Europe continue to have material home sovereign exposures (see charts 5 and 6). Conversely, most banks in western Europe and the Nordics typically exhibit relatively lower exposures. In our view, this is because banks in central, southern, and eastern Europe hold large excess liquidity and face limited domestic demand for credit. Since they lack better lending opportunities, they turn to the debt markets, where sovereigns remain the main sources of supply. In some central and eastern European countries like Poland, Czechia, and Hungary, banks also have direct tax incentives to hold more government bonds on their balance sheets. In countries such as Portugal or Italy, where banks' home sovereign exposures are also large, banks tend to favor their home sovereign's debt instruments because of the relatively higher yields that they provide, compared with other higher-rated eurozone sovereigns.

Chart 5

Chart 6

EU Banks' Home Sovereign Exposures Will Gradually Increase...

We expect EU banks' domestic sovereign bond holdings will rise over time, which will reinforce the sovereign-bank nexus. We have identified two reasons for the increase in banks' exposures to their home sovereigns.

1 – Cyclical changes in EU government bond markets

Cyclical changes include sovereigns' elevated funding needs in light of still significant fiscal deficits and the need to finance investments in green and digital transitions, as well as central banks' withdrawal from the government bond market because of ongoing quantitative tightening programs. Unlike quantitative easing, which has contributed significantly to the decline in EU banks' sovereign exposures since 2015, we consider quantitative tightening will increase banks' sovereign exposures.

2 – Structural incentives

EU banking regulations continue to provide a preferential treatment to sovereign debt, both from a capital and liquidity requirement perspective. EU government bonds are treated as risk-free assets in the case of regulatory capital ratios under the credit risk standardized approach, and as level 1 high-quality liquid assets--which are not subject to haircuts--in the case of regulatory liquidity ratios. Beyond that, banks continue to hold government bond portfolios as part of their interest rate and foreign exchange risk management practices.

...But Remain Potential Credit And Market Risk Sources For Some EU Banks

EU sovereigns' creditworthiness and, consequently, the ratings on EU sovereigns have gradually improved since 2014 (see chart 7). When assigning equal weight to each of the 27 member states, we observe that average sovereign ratings have improved from a low of 'A-' in 2013 to the current 'A+' level, which is a two-notch upgrade over 10 years. This is a positive development for European banks' sovereign portfolios as it suggests that sovereign risk has decreased over time.

That said, it is important to note that the credit risk embedded in banks' EU sovereign debt portfolios differs, depending on the underlying sovereign. The EU banking regulations do not take this discrepancy into account and treat all exposures to EU sovereigns preferentially from a capital and liquidity requirement perspective.

Chart 7

Yet, incorporating sovereign exposures' credit risk would deteriorate some banks' reported regulatory capital ratios materially. In December 2017, the Basel Committee on Banking Supervision (BCBS) published a discussion paper and presented a calibration of regulatory risk weights for domestic sovereign exposures. While we continue to view the suggestions as a positive step toward addressing the sovereign-bank nexus, we believe the illustrated risk weights for sovereign exposures do not sufficiently reflect true default risks across the rating scale. What's more, policy interest in Europe for the BCBS's proposals has been limited. For example, the regulatory treatment of sovereign exposures was not among the main priorities of the Eurogroup meeting in June 2022, even though it is a relevant agenda point. As such, we do not expect that the current regulation in the EU will change in the near term.

The effect of risk-weighting

In our bank capital adequacy analyses, we calculate our own risk-adjusted capital (RAC) ratio for rated banks and assign non-zero risk weights to local and foreign currency sovereign exposures, based on the issuer credit rating (see table 2). Using reported data on 70 large EU banks subject to the 2023 EBA stress test, we applied our RAC framework to assign risk weights to their sovereign credit risk exposures, considering static balance sheets and ignoring banks' counterbalancing measures. This risk-weighting exercise reduced the CET1 ratios for the banks in the sample by 0.7% (see charts 8 and 9). The risk-adjusted CET1 ratios vary considerably across banks. The capital hit is notably higher for institutions that operate in countries with lower sovereign credit ratings and larger home sovereign debt holdings on their books, particularly Italy, Greece, Spain, and Hungary. Additionally, major Austrian banks, whose subsidiaries in central and eastern Europe carry substantial home sovereign exposures, would experience a CET1 ratio decrease of approximately 0.5%-1.0%.

If sovereign exposures' credit risk were factored in, all 70 EU banks would still maintain sufficient capital levels to meet their minimum capital requirements. However, the substantial reduction in CET1 ratios due to the risk-weighting of sovereign exposures supports our conviction that many European banks' capital ratios benefit substantially from the existing regulation, under which sovereign risk is a non-existent risk. The 47 banks for which the risk-adjusted CET1 ratio decreases would require a total of €48 billion in additional capital to maintain their CET1 ratios. Collectively, CET1 capital would have to increase by 6.7% to compensate for the higher sovereign risk weights. For the 10 banks facing the largest percentage point drop in CET1 ratios, CET1 capital would have to increase 16%-55% to offset higher risk-weighted assets.

Chart 8

Chart 9

Sovereign debt also carries meaningful interest rate and credit spread risk for banks

Sovereign bond portfolios bear significant interest rate and credit spread risks, given their mostly fixed-rate nature and their significance as financial assets on banks' and non-banks' balance sheets. A failure of interest risk management on these portfolios was a driver of the market turmoil that affected certain U.S. regional banks in March 2023. In Europe, we consider that a prudent management of interest rate risks under an effective regulatory framework is a source of resilience. Yet, this resilience would be further tested if interest rate volatility were to rise.

In central and eastern Europe, central banks started their rate tightening cycle earlier than the ECB. Poland and Hungary have already started to lower key rates. Significant uncertainties regarding the timing and scale of rate reductions across central and eastern Europe remain.

Weak Growth And Diverging Economic Policies Could Put The Sovereign-Bank Nexus Back Into The Spotlight In 2024

A sluggish manufacturing sector, weak external demand, and still elevated energy costs intensify the risk of a recession for some European economies. At the same time, the future speed and magnitude of EU fiscal and monetary policies is not all that clear. The escape clause of the EU stability and growth pact will expire at the end of the 2023, while uncertainties on the speed and scale of central banks' actions prevail. In this context, the sovereign-bank nexus could come under financial market scrutiny again. Three risks could propel this development.

1 – Delayed or insufficient fiscal consolidation leading to a loss of market confidence in a sovereign, with ripple effects on banks' funding conditions

Growing fiscal policy disagreements among EU member states could contribute to heightened market volatility and result in a loss of investor confidence in the worst-case scenario. The mini-budget episode in the U.K. has shown how quickly fiscal policy mismanagement can curb market confidence in a sovereign, particularly during periods of volatility, exacerbated by collateral requirements and other technical factors. Under the new EU stability and growth pact, EU member states will be required to demonstrate their commitment to maintaining a general government deficit below 3% of GDP after 2023. They must also ensure that their primary spending growth remains in line with country-specific recommendations and present credible plans for significant debt reductions.

As such, some EU governments' budgets may face increasing investor scrutiny to determine if they prioritize fiscal tightening and whether their budgetary paths align with EU standards, in a context where debt-servicing costs will represent a significant portion of GDP in some countries (see chart 10). This could strain governing coalitions in some EU countries and negatively affect their sovereign bond yields, in our view. Not surprisingly, investors are already pricing in credit risks for EU countries with weaker growth prospects and larger underlying budgetary deficits. We note that in some markets in central and eastern Europe and the European periphery credit default swap spreads are correlated with banks' sovereign exposures on balance sheet (see chart 11).

That said, we see the occurrence of an episode similar to the U.K. mini-budget crisis as unlikely in the eurozone. This is because of the ECB's existing risk management tools, such as the Transmission Protection Instrument, but also because of the fiscal surveillance conducted by the European Commission, which should, in theory, reduce the risk of an uncoordinated decision by an EU member state to increase budgetary deficits. Finally, the euro is a major global reserve currency, making it largely inescapable for foreign investors–-although they certainly keep a choice between various EU member states' sovereign debt instruments.

Chart 10

Chart 11

Chart 12

2 – Too restrictive fiscal policies hurting growth, with ripple effects on banks' business volumes and asset quality

The increase in government debt relative to GDP since the pandemic and the rise in the cost of new debt will constrain policymakers' ability to renew fiscal support to the private sector. As the EU is set to re-introduce some version of its fiscal rules in 2024, we expect that fiscal policy will be a drag on economic growth commencing next year in nearly all member states. Most have a long way to go to bring expenditure levels back to pre-pandemic levels, excluding Cyprus and Ireland, where 2023 general government spending levels remain above 2019 levels by more than 3 percentage points of GDP. A continuation of accommodative fiscal policies would run counter to central banks' goals to bring down inflation, as publicly stated by the ECB. Another source of fiscal pressure comes from the sharp fall-off in expected dividend payments from national central banks to their national treasuries, as central banks are no longer earning interest rate margins on their past bond acquisitions under now discontinued asset purchase programs.

Alongside the risk of an excessively relaxed fiscal policy, there is the alternative risk of a return to excessively austere budgetary policies, even as higher interest rates dampen private spending, with negative implications for domestic economies. For banks, this would add to restrictive monetary policies and compound the negative headwinds for business growth and asset quality.

3 – Too restrictive monetary policies creating significant interest rate and spread volatility, with ripple effects on banks' funding conditions

The future path of monetary policies remains a key source of uncertainty for EU banks. Overly restrictive policies are a clear downside risk. In the eurozone, the ECB announced a review of its operational framework by spring 2024. Future decisions could include an acceleration of quantitative tightening, including a switch from passive to active forms of quantitative tightening, or a hike in the level of unremunerated minimum reserves. For eurozone banks, the effects would be a further tightening in funding conditions, with differences across systems.

In central and eastern Europe, the key question will be the speed and scale at which central banks will bring down interest rates after very substantial hikes in the past two years, in a context of rapid disinflation. Poland and Hungary have started to bring down rates, but no other central banks have followed their example so far.

The Sovereign-Bank Nexus Remains An Obstacle To Further EU Financial Integration

In the past decade, authorities focused their efforts on reducing the most problematic leg of the sovereign-bank nexus, namely the cost of bank failures for sovereigns. The main policy innovation was the introduction of an effective resolution regime, whereby primarily banks' own creditors or the banking system would bear the cost of bank failures, with no taxpayer involvement. European regulators seem generally satisfied with the progress banks have made toward full resolvability, while we have upgraded many banks for similar reasons over recent years.

At the same time, other aspects of the sovereign-bank nexus, such as banks' direct exposures to their home sovereigns or the concentration of EU banks' business within their domestic markets, still require a lot of work. Importantly, the sovereign-bank nexus is a significant impediment to progress on further EU financial integration initiatives, such as the establishment of an EDIS. Some EU policymakers consider that an EDIS would spread the risk of bank failures across the entire EU, instead of containing it within individual member countries. A reduction of the sovereign-bank nexus could help--otherwise, an EDIS would lead to a mutualization of sovereign risks across the EU, which is a political red line for some EU member states. Since fragmented national markets lack the benefits of economies of scale, he lack of banking and financial market integration is one of the key obstacles to banks' broader competitiveness.

Appendix

Domestic exposure bias means that we rarely rate banks above their sovereign

Sovereign risk plays an important role in determining bank ratings. A weakening economy and a decline in the sovereign's creditworthiness can translate into significant valuation or even credit losses for financial institutions. Prominent examples include Greece during the European debt crisis in 2009 and 2010 and Argentina's default in 2020, which led to substantial rating downgrades for banks in the country.

When a bank's intrinsic creditworthiness appears to be stronger than that of its sovereign, we implement a stress test on its capital and liquidity positions to assess its potential resilience to a hypothetical sovereign default. We observe that a rapid deterioration in the home sovereign's creditworthiness can trigger bank runs and result in a substantial capital depletion. In practice, very few banks would pass this stress test because their securities and loan exposures tend to exhibit a strong home country bias. Banks that exhibit a reasonable likelihood of not defaulting in the face of a sovereign default tend to have highly diversified business operations outside their home countries. Of the about 1,100 banks we rate globally, only six bank ratings are higher than the ratings on their home sovereigns (see table 1).

Table 1

Table 2

Related Research

• Eurozone Banks: Higher Reserve Requirements Would Dent Profits And Liquidity, Oct. 24, 2023
• The Resolution Story For Europe's Banks: Making The Regime Fit For Purpose, Oct. 4, 2023
• Credit Conditions Europe Q4 2023: Resilience Under Pressure Amid Tighter Financial Conditions, Sept. 26, 2023
• Economic Outlook Eurozone Q4 2023: Slower Growth, Faster Tightening, Sept. 25, 2023
• Credit FAQ Looks At What An Acceleration Of Quantitative Tightening Could Mean For Eurozone Banks, Sept. 13, 2023
• European Banks: Potential Interest Rate Volatility Calls For Caution, July 19, 2023
• European Developed Sovereign Rating Trends Midyear 2023: A Time Of Transition, July 13, 2023
• Unrealized Losses: The Rate-Rise Risk Facing Banks, March 16, 2023
• United Kingdom Outlook Revised To Negative On Rising Fiscal Risks; 'AA/A-1+' Ratings Affirmed, Sept. 30, 2022
• The European Sovereign-Bank Nexus Deepens By €200 Billion, Sept. 21, 2020
• Basel Paper On Banks' Sovereign Exposures: Not Enough To Undo The Doom Loop, March 8, 2018

Designers: Tim Hellyer, Tom Lowenstein. Editor: Kathrin Schindler.