It is often argued that banks should be allowed to buy large amounts of their own sovereign debt because this way they can stabilize the market in a crisis. But there are two reasons why bank buying the bonds of their domestic governments cannot have a large positive impact on bond prices.
First of all, sovereign debt holdings by banks should not be regarded as an additional demand for public debt. Banks are just intermediaries for private savings. Any sovereign debt on the balance sheet of a bank could also be held directly by household (as long as it is in the form of a tradable instrument). The disadvantage of banks holding a substantial proportion of public debt is that they are leveraged. This leverage multiplies the potential impact of any loss of value of sovereign debt on the economy (the famous diabolic loop). Governments should make it more attractive for households (and other real money investors) to hold government debt directly. Getting banks out of the business of financing the government would reduce overall leverage in the economy, and would help to reduce the size of the European Banking sector which is widely regarded as excessive. The example of the US, where banks do not hold significant amount of public debt, shows that there is no need to rely on banks to support a large debt level.
A second reason why large bond buying by banks cannot be expected to stabilize markets is that the (marginal) funding cost for banks is usually higher than that of the sovereign (at least for market instruments, like bank bonds). Ratings agencies usually have a rating limit for corporates headquartered in a country, which is given by the sovereign rating. Another reason is that ratings agencies (and investors in general) expect the home government to stand behind its banks when they experience difficulties (the recent experience with the Venetian banks shows that this remains the case even under the new ‘bail-in’ regime).
In reality banks have indeed in general a higher funding cost than their own government. This has an important implication: the interest margin on government bonds must be negative. In turn, this means that one cannot argue that banks buying their own sovereign debt can stabilize the market. On the contrary, if an intermediary with higher funding cost than the sovereign buys sovereign bonds the overall cost can only increase. This is indeed what happened in Italy during 2011/2, when the tensions was strongest: banks continue to issue their own bonds at a cost substantially above the cost of the Italian government, and then bought large amounts of BTPs. The negative carry was considerable and must have weakened the banks further. One can of course argue that in the presence of denomination risk, banks might have an incentive to hold domestic bonds in order to minimize the potential ‘currency mismatch’. But this argument can explain why banks might have an incentive to concentrate their holdings of government bonds on domestic paper; but even in the presence of denomination risk it does not make sense to buy more domestic government bonds when these purchases have to be finance with higher cost bank bonds. Moreover, during an acute crisis the difference in yields goes up. Large bond buying during crisis times thus risks to aggravate financial market stress crisis instead of mitigating it.
Banks are of course always tempted to finance themselves cheaply short term and then make long term investments (this is called maturity mismatch). For the normal banking business of collecting short term deposits to fund medium term loans to enterprises (or longer term mortgages) this maturity mismatch is unavoidable. But there is no structural need for banks to issue short term paper to fund investments in longer term government bonds. This business model is fit more for a hedge fund than a bank. Moreover, the yield curve has been so flat for so long now that differences in maturity cannot easily overcome the funding cost handicap of banks vis-à-vis their own sovereign.
Even a cursory look at the funding structure of Italian banks shows the importance of this argument: Italian banks have over 500 billion euro in bonds and other debt instruments outstanding and they hold a little over 400 billion euro in bank bonds. Given that the cost of the bank bonds is higher than the return on government paper, this means that the banks would be better off reducing their bonds outstanding and getting rid of their government bonds. The net demand for government bonds would not need to fall as the same savers who now hold bank bonds in their portfolios (mostly ‘administered’ by the banks) could hold government bonds instead.
Finally, one has to distinguish between ex ante and ex post. When a bank has large exposure to its home sovereign, it will be affected strongly when a new crisis starts as the value of the bonds on its balance sheet will fall. The regulatory capital position might not be affected since government debt can be held to maturity so that its market value does not enter into the calculations for the regulatory capital requirements. But market participants can make their own calculations and will in general mark down the value of the bank’s equity on the basis of market to market losses. It follows that the country would be less affected by financial stress if at the start of a crisis its banks held little domestic public debt. It would thus be desirable to reduce the existing large exposures to domestic public debt, even if one follows the argument that banks can become the buyers of last resort for public debt in a crisis. The less banks hold at the beginning of the crisis the more they would be able to buy. The potential instability is of course even greater if banks during tranquil times use short term instruments to fund investments in long term government bonds. An increase in the risk premium would then add liquidity problems to the mark to market losses.
Banks have to hold a substantial amount of government bonds anyway under the so-called ‘liquidity coverage ratio’ or LCR, which forces banks to have enough liquid assets to cover the cash needs that could rise under certain standardized scenarios of a withdrawal of deposits and other events requiring cash in hand. Banks can satisfy the LCR in principle using any asset, which can be quickly converted into cash. But the regulations make government bonds de facto the main asset to be used for the LCR.
The question is thus not whether banks should hold any government bonds at all, but rather whether encouraging banks to hold large amount of home government bonds is a good idea. Encouraging banks to hold home government bonds in excess of the minimum required by the LCR could actually weaken both banks and government finances. Moreover, even those holdings necessary under the LCR should be diversified to avoid linking the fate of the banks too much to that of their own sovereign. Governments should stop looking to their banks as source of financing of large public debts and start selling their bonds directly to the ultimate investors, namely domestic households.