The European Sovereign Debt Crisis

Breaking the Vicious Circle between Sovereigns and Banks

Phoebus L. Athanassiou, Angelos T. Vouldis

• Publisher: Routledge
• Year: 2021
• Print ISBN: 9781032030555
• eBook ISBN: 9781000423099
• Edition: 1
• Topic: Law
• Subtopic: Financial Law
• Index: Law

The European Sovereign Debt Crisis: Breaking the Vicious Circle between Sovereigns and Banks explains why the euro area's progress towards reining in the risks arising from the well-documented bi-directional financial contagion transmission mechanism that links sovereigns to commercial banks has been more prominent compared to the channel of contagion moving from banks to sovereigns.

Providing an analysis of the legal and regulatory measures that Europe and the euro area have taken to mitigate the exposure of sovereigns to financial crises generated by commercial banks, this book draws attention to areas where improvements to the arsenal of tools hitherto introduced are either desirable or necessary. Chapters further explain – with recourse to economic and legal arguments – why the channel of contagion moving from sovereigns to commercial banks has proven harder to close, and explores ways in which progress could be made in the direction of closing it so as to avert the risk of future banking sector crises.

This work provides essential reading for students, researchers and practitioners with an interest in sovereign debt crises and the euro-area banking system.

1 The sovereign–banks nexus

An economic analysis

1.1 Introductory remarks

This chapter explores the sovereign–banks nexus from the perspective of economic theory and with the benefit of relevant empirical evidence. Its first analytical section seeks to explain why commercial banks choose to hold national domestic debt. The aim of its second analytical section is to analyse the feedback loop between sovereigns and their banks, triggered by the direct holding, by the latter, of sovereign debt but, also, by a number of other complementary transmission mechanisms. The analytical component of this chapter is preceded by an introductory section, which traces the history of the funding of sovereigns by banks, with a view to adding some historical context to our discussion of the current state of affairs. The focus of this chapter is on elements that are of particular relevance for countries participating in a monetary union, such as the EMU.

1.2 Brief historical overview

The direct funding of sovereigns by banks was already widespread in the Italian city-states of the 12th century, often in the form of compulsory lending repayable by tax revenues.¹ The public debt holdings of the members of the governing élites of the Italian city-states has been considered as a credibility mechanism against default,² as it reinforced the incentives of governing officials to follow a sound public policy. Later, the public banks that appeared in 15th-century Europe, especially in commercial centres, were often subject to ‘fiscal exploitation’ by their respective cities or republics, more often than not in order to finance wars or military adventures.³ Indeed, it was in order to facilitate the government lending necessary to finance the war effort against France (1689–1697) that the Bank of England was established in 1694. According to the seminal analysis of North and Weingast,⁴ the aim of the constraints placed by the new institutional set-up on the Crown’s ability to borrow from the Bank of England (only possible with the explicit consent of Parliament) was to underpin the credibility of public finances and to mark a break with the past, when ‘forced loans’ were the norm. The new set-up resulted in lower capital costs for entrepreneurs, thereby supporting the incipient Industrial Revolution.⁵

¹ Michele Fratianni and Franco Spinelli, ‘Italian City-States and Financial Evolution’ (2006) 10 European Review of Economic History 257.

² Reinhold C. Mueller, The Venetian Money Market Banks, Panics and the Public Debt, 1200–1500 (Baltimore, Maryland, The John Hopkins University Press 1997), Ch. 12.

³ William Roberds and François Velde, ‘Early Public Banks’ (2014) Federal Reserve Bank of Chicago Working Paper 2014-03 <https://ideas.repec.org/p/fip/fedawp/2014-09.html> accessed 30 September 2020.

⁴ Douglass C. North and Barry R. Weingast, ‘Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England’ (1989) 49 Journal of Economic History 803.

⁵ There are criticisms of this view, see, for example, Nathan Sussman and Yishay Yafeh, ‘Institutional Reforms, Financial Development and Sovereign Debt: Britain 1690–1790’ (2006) 66 (5) Journal of Economic History 906.

Recurring cycles of sovereign debt increases were observed during the 20th century, especially during the two World Wars. These were followed by a clear downward trend during the 1950s and the 1960s and by a gradual increase after the 1970s. The aftermath of the global financial crisis of 2007–2009 has seen a further increase. In addition, there is evidence, in advanced economies, of heightened sovereign debt holdings by domestic commercial banks during crisis periods, such as the two World Wars and the economic crises of the 1970s.⁶

⁶ S.M. Ali Abbas, Laura Blattner, Mark De Broeck, Asmaa El-Ganainy and Malin Hu, ‘Sovereign Debt Composition in Advanced Economies: A Historical Perspective’ (2014) International Monetary Fund Working Paper WP/14/162 <https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Sovereign-Debt-Composition-in-Advanced-Economies-A-Historical-Perspective-41899> accessed 30 September 2020.

What this very brief historical overview shows is that the link between banks and state finances is hardly a novelty and that a pattern of banks holding increased amounts of sovereign debt, especially at times of crisis, is discernible throughout history, although the reasons for it may well differ from one case to another.

1.3 Why do banks hold domestic sovereign debt?

1.3.1 Discrimination and selective defaults

In trying to explain why banks may choose to hold domestic sovereign debt, a line of research has focused on the desire of banks to earn a price subsidy on them, as their holding may entail lower credit risks compared to those that foreign investors face as holders of the same domestic sovereign debt. The assumption is that, in the event of default, the sovereign issuer will discriminate against the foreign holders of its debt by choosing to pay domestic holders instead. In other words, it is assumed that sovereigns will prefer to selectively default on the foreign holders of sovereign debt in order not to harm domestic investors. This subsidisation of domestic holders is thought to provide an incentive for them to hold domestic sovereign debt since it mitigates their effective credit risk.

Broner, Didier, Erce and Schmukler⁷ argue that the pattern of capital flows and, specifically, the retrenchment observed during crises (i.e. the collapse of gross capital flows) is consistent with the above idea of a differential credit risk between foreign and domestic investors in domestic sovereign debt. This pattern is also supported by previous research⁸ according to which, during periods of heightened sovereign default risk, foreign investors will seek to sell their sovereign debt assets to domestic investors, who have an incentive to buy them in the expectation that their issuer will prioritise their repayment. In this line of research, the possibility of discrimination among foreign and domestic creditors is an exogenous assumption, which is posited to explain other patterns in the data, especially with regard to capital flows.

⁷ Fernando Broner, Tatiana Didier, Aitor Erce and Sergio Schmukler, ‘Gross Capital Flows: Dynamics and Crises’ (2013) 60 Journal of Monetary Economics 113.

⁸ Fernando Broner, Alberto Martin and Jaume Ventura, ‘Sovereign Risk and Secondary Markets’ (2010) 100 American Economic Review 1523.

Erce and Mallucci⁹ empirically examine selective sovereign defaults (defined as defaults with an element of discrimination between domestic and foreign investors in sovereign debt). A challenge in such empirical analyses is to distinguish in the dataset between domestic and foreign investors, as their residence is not, normally, determined. Erce and Mallucci choose to define investors based on the legal regime governing instruments in default, while Reinhart and Rogoff¹⁰ choose to classify domestic and external defaults based on the currency of denomination of the instruments in default. Both approaches are expected to lead to relevant proxies for the origin of investors. In the assembled dataset, it is found that only 28 out of the 182 default episodes were joint defaults (defined as defaults where the sovereign defaulted without discriminating across instruments or their investors). What one could conclude from this empirical study is that selective defaults are, in practice, common. The same study also finds that the impact of a default on the domestic economy is felt via two different channels, depending on the type of selective default. If a country defaults on its ‘domestic’ bonds (as defined above) then a contraction in domestic credit represents the most active channel (‘credit channel’), whilst where default is on its ‘foreign’ bonds then it is the loss of access to foreign intermediaries that has the strongest adverse effect on the domestic economy (‘trade channel’).

⁹ Aitor Erce and Enrico Mallucci, ‘Selective Sovereign Defaults’ (2018) Board of Governors of the Federal Reserve System, International Finance Discussion Paper 1239 <https://www.federalreserve.gov/econres/ifdp/files/ifdp1239.pdf> accessed 30 September 2020.

¹⁰ Carmen M. Reinhart and Kenneth S. Rogoff, ‘The Forgotten History of Domestic Debt’ (2008) National Bureau of Economic Research Working Paper 13946 <https://www.nber.org/papers/w13946> accessed 30 September 2020.

It is possible to question the relevance of selective default to advanced economies and, a fortiori, to the economies of EU countries. In the Erce and Mallucci dataset, the sample of countries in default includes only two advanced economies, with all remaining economies in the sample comprising emerging and developing countries. Specifically, the Greek default of 2011 is classified as a joint default, while the Cypriot default of 2013 is classified as a domestic default. In addition to the low representation of advanced countries in the sample, the case of Cyprus involves a sui generis case of ‘discrimination’ against domestic investors that runs against the grain of the literature surveyed above. The (temporary) default of Cyprus was due to a ‘distressed exchange’ of domestic sovereign bonds, used as a public debt liquidity management tool. Therefore, none of the two advanced economies in the sample of the Erce and Mallucci dataset actually discriminated against foreign investors.

In general, there are significant caveats in the classification of defaults as having actually affected domestic or foreign investors, given that sovereign bonds are actively traded in the secondary markets, and the identity of their holders, at the time of default, cannot readily be determined. In addition, in the context of the EU, foreign investors would (also) include those hailing from other countries of the Union: a selective default scenario against other EU Member States would not seem to be one that market participants could discount when making their portfolio choices (hence, not a persuasive explanation for the home bias of banks’ sovereign debt holdings). Overall, even if discrimination among different classes of investors (or, more accurately, instruments) may be an empirical fact across many sovereign default cases, it does not seem to be the most relevant explanation for the decision of commercial banks in the EU to hold domestic sovereign debt.

1.3.2 Pro-cyclicality of sovereign debt

Another line of reasoning that seeks to explain why banks choose to hold domestic sovereign debt stresses the liquidity aspect of domestic sovereign bonds, which allows banks to use them to expand their credit portfolios when there are abundant investment opportunities, i.e. when the economy is growing. A complementary element of this explanation is the pro-cyclical nature of the domestic sovereign debt from the perspective of domestic macroeconomic developments: the credit risk of sovereign bonds is minimal when the demand for positive net present value investments is higher, and vice versa. As a result, the usefulness of domestic sovereign debt to secure liquidity is higher exactly when it is needed the most. This pro-cyclical profile argument is also combined with another element, namely the bank owners’ limited liability: if the government defaults, potentially leading to the insolvency of a bank that holds sovereign debt, losses will be shifted to depositors instead of being absorbed by the bank’s owners. This set of considerations provides an explanation for the attractiveness of domestic sovereign bonds as an investment option.

In the stylised model of Gennaioli, Martin and Rossi,¹¹ when the macroeconomy experiences an upswing, banks can use their domestic sovereign bond holdings to obtain liquidity and finance available projects with a rate of return above risk-free investments. In case of a sovereign default, the...

Table of contents

• Cover
• Half-Title
• Series
• Title
• Copyright
• Contents
• List of main legal instruments and sources
• List of cases
• List of abbreviations and acronyms
• Preface
• Introduction
• 1 The sovereign–banks nexus: An economic analysis
• 2 Case studies from the European sovereign debt crisis
• 3 An economic analysis of policy options
• 4 Closing the first channel of contagion from banks to sovereigns: Hitherto European actions and their critique
• 5 Closing the second channel of contagion from sovereigns to banks: Legal assessment of policy options
• Concluding remarks
• Bibliography
• Index