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