Domestic banks have ramped up their holdings of sovereign debt since the financial crisis erupted a few years ago.
However, if confidence in the sovereign is undermined then it can have negative consequences for the banking system which would damage the wider economy, according to an IMF study of the sovereign debt markets.
Even if a country has a high proportion of international investors holding its debt, it faces huge refinancing risks in the event that country is downgraded and investors offload their positions.
“In the short run, higher domestic bank ownership of sovereign debt may help provide a more stable investor base for the government,” the IMF said.
“However, in the longer run, any deterioration in the sovereign’s credit risk can trickle into the health of the domestic banking system. In turn, contingent liability risks from the bank to the sovereign may increase.
“In order to reduce these negative feedback loops, strengthening backstop mechanisms to support banking systems, along with higher loss-absorbing capital at the banks may be needed.
“Financial authorities may also need to consider conducting regular systemic stress tests with credible sovereign risk scenarios.”
The study looked at sovereign debt flows in and out of all major western economies between 2004 and 2011.
There was a high ownership of Irish government debt until the first quarter of 2010. This was reduced following the first ratings downgrade and decreased substantially following further downgrades.
The study found that even before the crisis there was a bias among domestic banks to hold high levels of sovereign debt. The pre-crisis average was 57%, but hit 69% by the end of last year.
The global recession caused a significant decrease in the demand for loans. Banks accumulated government debt instead.
Moreover, banks are in the process of deleveraging in a bit to shrink their balance sheets. Consequently the incentive is to hold sovereign debt because it is a very low-risk weighted asset.
As banks concentrate their holdings on sovereign debt, this decreases the level of lending to the wider economy, which has knock-on consequences for growth.
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