Banks' home bias in government bond holdings: Will banks in low‐rated countries invest in European safe bonds (ESBies)?

• Date: 01 September 2020
• Published date: 01 September 2020
• Author: Jean Dermine
• DOI: http://doi.org/10.1111/eufm.12259

Eur Financ Manag. 2020;26:841–858. wileyonlinelibrary.com/journal/eufm © 2020 John Wiley & Sons Ltd.

|

841

DOI: 10.1111/eufm.12259

ORIGINAL ARTICLE

Banks' home bias in government bond

holdings: Will banks in low‐rated countries

invest in European safe bonds (ESBies)?

Jean Dermine

INSEAD, Fontainebleau, France

Correspondence

Jean Dermine, Professor of Banking and

Finance, INSEAD, Boulevard de Constance,

F‐77300 Fontainebleau, France.

Email: jean.dermine@insead.edu

Abstract

This paper offers two new explanations for banks'

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 ex-

planations offered in the literature: risk‐shifting,

gambling for resurrection, moral suasion, and a

means to store liquidity for financing future invest-

ment. Collectively, they cast doubt on the European

Union's demand‐led approach to investment in Eur-

opean safe bonds (ESBies) 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.’

KEYWORDS

bank regulation, banks' home bias, Basel capital, European

banking

JEL CLASSIFICATION

F34; G21; G28

EUROPEAN

FINANCIAL MANAGEMENT

The author acknowledges the comments of the editor of the journal, an anonymous referee, I. Angeloni, I. Dermine, P.

Fulghieri, L. Tepla, and P. Ventaneira.

1|INTRODUCTION

Since the global financial crisis, banks' holdings of domestic government bonds have received

increased attention from central banks, bank supervisors, the European Commission, the Bank

for International Settlements, and the academic community.

A‘diabolic loop’has been identified in the sovereign–bank nexus (Acharya, Drechsler, &

Schnabl, 2014; Brunnermeier et al., 2016; Fahri & Tirole, 2018) whereby, in the event of a

sovereign crisis, losses on domestic government bond holdings can destabilize the banking

system, leading to a reduction in bank lending, which will in turn deepen the crisis. The vicious

cycle is aggravated further if the destabilization of banks leads to a need for a costly bailout.

The Basel Committee on Banking Supervision (2017,2019) has launched a review of its

regulatory treatment of sovereign exposures (RTSE). Building on an academic proposal

(Brunnermeier et al., 2011,2016), the European Commission (2017a,2017b) and the European

Systemic Risk Board (2018) propose the creation of super‐safe sovereign bond‐backed securities

(SBBS) to increase the stability of the European banking union. Safe bonds would replace risky

domestic government bonds in banks' sovereign bond portfolios. But will banks in low‐rated

countries invest in these safe assets? This is the question examined in this paper.

1

Following a review of the literature on banks' home bias in government bond holdings, we

propose two new complementary explanations: a sovereign cap on corporate ratings applied by

rating agencies and a ‘bank tax’on surviving banks. To the best of our knowledge, these have

not previously been discussed in the sovereign–bank nexus literature. They underscore the

difficulty of creating a banking union in the presence of national fiscal authorities. Under-

standing the economic rationale for holding safe or risky government bonds allows us to assess

the likelihood of demand for super‐safe bonds by banks and discuss the supposed crowding out

of corporate lending that results from the holding of government bonds.

The literature on the home bias in banks' bond holdings and the merits of creating super‐

safe bonds is reviewed in section 2. The two additional arguments for the holding of domestic

government bonds are presented in section 3. A formal model of the banking firm and the

choice between risky loans, risky government bonds, and safe bonds follows in section 4.

2|REVIEW OF THE LITERATURE

In a Modigliani–Miller world with perfect information, zero cost of bankruptcy, and no or

perfectly priced deposit insurance, the choice of government bond holdings should not matter.

Indeed, one bank valuation model (Dermine, 2007) shows that the value of its equity is the sum

of two components: the current liquidation value of assets net of liabilities, and a franchise

value on its loans and deposits. Franchise value is created by the bank borrowing at a rate below

the market rate or lending at a rate above the market. There is no franchise value on bonds

priced in a perfectly competitive market because bank shareholders can buy government bonds

themselves. The choice of government bonds –low or high risk –should not create any value.

2

1

Besides the financial stability issue with bank diversification of sovereign risk, there exists a second motivation for the creation of safe bonds: increasing their

supply is useful for macroeconomic reasons such as the creation of a liquid safe asset market that provides a benchmark to price assets and high‐quality

collateral to access market‐based funding (Caballero, Farhi, & Gourinchas, 2017; European Systemic Risk Board, 2018). The current paper deals exclusively

with the issue of financial stability.

2

The choice of bonds does not matter unless a bank's management has a superior ability to identify mispriced securities.

842

|

EUROPEAN

FINANCIAL MANAGEMENT

DERMINE