ISSUE 2012/02 FEBRUARY 2011 WHO’S AFRAID OF SOVEREIGN BONDS?

• The crisis has underlined the strong interdependence between the euro-area banking and sovereign crises. To understand the role domestic banks have played in holding sovereign debt, a breakdown of government debt by holding sectors is required. • The data shows that at the start of the crisis, most continental euro-area countries were characterised by the large size of their banks ’ portfolios of domestic government bonds, which were markedly larger than in the UK or the US. Consequently, concern about sovereign solvency was bound to have major consequences for banks. • The structural vulnerability of euro-area countries has increased, reinforcing the sove-reign/banking crisis vicious cycle. All countries for which concerns about state sol-vency arose in recent years have seen a reversal in the previously steady increase of the share of government debt held by non residents. Germany, by contrast, has seen an increase in the share held by non residents. • In the short term, these observations raise a question about the effectiveness of ECB provision of liquidity to banks as a means to alleviate the sovereign crisis. At a point when government bonds are considered risky assets, euro-area banks are faced with both balance sheet and reputational risks compared to their non-euro area counterparts, and may prove reluctant to increase this exposure further. • In the longer term, the question is if and how euro-area regulators should set incentives to reduce banks ’ heavy exposure to sovereigns. This issue should be given more attention in European policy discussions on how to strengthen the euro area