- Unconventional monetary policy shocks in the euro area and the sovereign-bank nexus
In this paper, we explore the effects of the ECB’s unconventional monetary policy on the balance sheet exposure of a country’s banking sector to the debt issued by the national government, i.e. the so-called sovereign-bank nexus. The nexus is considered of primary importance for the medium-term stability of the financial system (Basel Committee on Banking Supervision, 2017; IMF, 2018; Battistini et al., 2014; Brunnermeier et al., 2016; Farhi and Tirole, 2018, among others). On the one hand, a higher share of bond holdings is typically associated with a better liquidity position of banks, thus being favourable for the soundness of the banking system (Walther, 2016; Richter et al., 2017; Hoerova et al., 2018), and may even reduce the incentives for the sovereign to default (Gennaioli et al., 2018; Basel Committee on Banking Supervision, 2017). On the other hand, a stronger nexus may harm financial stability by making the national banking sector more sensitive to deteriorations in the sovereign’s creditworthiness and may even contribute to the emergence of diabolic loops as repeatedly observed since the outbreak of the global financial crisis (Brunnermeier et al., 2016; Farhi and Tirole, 2018; Dell’Ariccia et al., 2018a). For example, many euro area countries experienced such a loop as the market value of banks’ holdings of domestic government bonds dropped due in the deterioration in the sovereign’s creditworthiness, thus putting a strain on the solidity of the banking sector. Governments responded by giving safety guarantees or even implementing substantial rescue packages, which, however, might potentially increase sovereign risk further and reinforce the impairment of banks’ balance sheets.