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

Author:Jean Dermine
Publication Date:01 Sep 2020
Eur Financ Manag. 2020;26:841858. © 2020 John Wiley & Sons Ltd.
DOI: 10.1111/eufm.12259
Banks' home bias in government bond
holdings: Will banks in lowrated countries
invest in European safe bonds (ESBies)?
Jean Dermine
INSEAD, Fontainebleau, France
Jean Dermine, Professor of Banking and
Finance, INSEAD, Boulevard de Constance,
F77300 Fontainebleau, France.
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: riskshifting,
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 demandled approach to investment in Eur-
opean safe bonds (ESBies) by banks in lowrated
countries. Bank regulations such as constraints on
large exposure or riskbased capital on credit risk
concentration will be needed if the objective is to
break the socalled deadly embrace.
bank regulation, banks' home bias, Basel capital, European
F34; G21; G28
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.
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.
Adiabolic loophas been identified in the sovereignbank 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 supersafe sovereign bondbacked 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 lowrated
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 taxon surviving banks. To the best of our knowledge, these have
not previously been discussed in the sovereignbank 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 supersafe 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.
In a ModiglianiMiller 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 highquality
collateral to access marketbased 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.

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