Banks, government bonds, and default

Banks, government bonds, and default

New evidence on banks and sovereign default risk

Regardless of the relevance of the phenomena, there is little systematic evidence on them. In recent work (Gennaioli et al. 2014b), we make an effort to fill this gap by documenting the hyperlink between public default, bank bondholdings, and loans. We utilize the BANKSCOPE dataset, which gives us with information on the bondholdings and characteristics of over 20,000 banks in 191 countries and 20 sovereign default episodes between 1998 and 2012. We address two broad questions:

1. Does banks’ contact with sovereign risk affect lending? Specifically, do the banks that hold more public bonds exhibit a more substantial fall in loans when their government defaults?

2. Why do banks buy public bonds, becoming subjected to default risk to begin with? Could it be because they buy bonds in normal times and so are then surprised by crises, or could it be because they actively chase risk during crises?

The purpose of our analysis is to document robust stylised facts rather than to recognize causal patterns, which our data will not allow us to accomplish. Our main findings are the following:

  • Holdings of public bonds are large in normal times, particularly for banks that produce fewer loans and so are situated in financially less developed countries. In non-defaulting countries, banks hang on average 9% of their assets in public areas bonds. Among countries that default at least one time (which are financially less developed), average bank bondholdings in non-default years are 13.5%. In both sets of countries, bondholdings in non-default years are decreasing in bonds’ expected return.
  • During default years, average bondholdings increase from 13.5% to 14.5% of bank assets. Critically, this increase is targeted in large banks. Moreover, during default years, bondholdings are increasing in bonds’ expected return.
  • During sovereign defaults, there exists a large, negative, and statistically significant correlation between banks’ bondholdings and subsequent lending activity. A one-dollar upsurge in bonds is connected with a 60-cent reduction in loans during defaults. Strikingly, about 90% of the decline is accounted for by the common bonds held by banks prior to the default occurs; only 10% of the decline is explained by the excess bonds bought in the run-up to and during default.

The transmission mechanism

Our results support the idea that banks’ holdings of public bonds are a significant transmission mechanism from sovereign defaults to bank lending. These findings are broadly in keeping with the next narrative. Public bonds have become liquid assets (e.g. Holmstrom and Tirole 1998) that play an essential role in banks’ everyday activities, like storing funds, posting collateral, or maintaining a cushion of safe assets (Bolton and Jeanne 2012, Gennaioli et al. 2014a). For that reason, banks hold a sizeable amount of government bonds throughout their regular business activity, especially in less financially developed countries where there are fewer alternatives. When default strikes, banks experience losses on the public bonds and subsequently decrease their lending. During default episodes, moreover, some banks deliberately retain their risky public bonds while some accumulate a lot more bonds. This behaviour could reflect banks’ reaching for yield (Acharya and Steffen 2013), or it may be their response to government moral suasion or bailout guarantees (Livshits and Schoors 2009, Broner et al. 2014). Whatever its origin, this behaviour is basically concentrated in a couple of large banks, and is connected with a further reduction in bank lending.

The need for banks’ bondholdings during normal times

One important feature of our dataset is that it covers a broad sample of default and non-default years. For that reason, it we can measure the relative contribution of bondholdings accumulated before and during sovereign defaults to the transmission of such events to private lending. The info give a rather clear result – in the countries and periods that people consider, average bondholdings in non-default years, which reflect banks’ normal business activity, play a significantly larger role than bonds accumulated in the run-up to and during default years. The primary driver because of this result is that, inside our sample of defaulting countries, banks hold many bonds in normal times (13.0% of assets) and the common upsurge in bondholdings during crises is quite small in comparison (significantly less than 2% of bank assets).

These results give a new perspective on the mechanisms whereby the sovereign default-banking crisis nexus makes existence and operates. A lot of the recent focus on this nexus has centered on the role of risk-taking by banks during crises. Although this might well be the proper technique for the European context, our panoramic view of sovereign debt crises demands paying close attention also to the bonds held by banks in normal times. This insight has both positive and, potentially, normative implications.

From a positive standpoint, our analysis shows that the unfolding of sovereign crises is fundamentally different in emerging and advanced economies. In the latter, the accumulation of bonds during crises is larger in accordance with total bondholdings, and is therefore apt to be responsible for a more substantial part of the adverse costs of defaults. From a normative standpoint, our results claim that caution could be warranted in modifying bank regulation to use higher risk weights to government bonds. If banks demand a sizeable amount of government bonds to handle their normal business activities, as appears to be specially the case in emerging economies, sovereign defaults will undermine the functioning of the banking sector and bank lending in addition to its risk-taking through the crisis itself. In this context, proposed regulations to improve the chance weight of government bonds during sovereign crises may backfire, because they could exacerbate the pro-cyclicality of bank balance sheets with no much of an impact on the hyperlink between sovereign risk and the banking sector.


Acharya, Viral V and Sascha Steffen (2013), “The best carry trade ever? Understanding Eurozone bank risks”, NBER Working Paper 19039.

Andritzky, Jochen R (2012), “Government bonds and their investors: What exactly are the reality and do they matter?”, IMF Working Paper.

Broner, Fernando, Aitor Erce, Alberto Martin, and Jaume Ventura (2014), “Sovereign Debt Markets in Turbulent Times: Creditor Discrimination and Crowding-Out Effects”, Journal of Monetary Economics, 61: 114-142.

Brutti, Filippo and Philip Sauré (2013), “Repatriation of Debt in the Euro Crisis: Evidence for the Secondary Market Theory”, mimeo, University of Zurich.

Gennaioli, Nicola, Alberto Martin, and Stefano Rossi (2014a), “Sovereign default, domestic banks, and finance institutions”, Journal of Finance, 69: 819-866.

Gennaioli, Nicola, Alberto Martin, and Stefano Rossi (2014b), “Banks, Government Bonds, and Default: What do the info Say?”, mimeo, CREI.

Holmström, Bengt and Jean Tirole (1998), “Market liquidity and performance monitoring”, Journal of Political Economy, 101: 678-709.

Livshits, Igor and Koen Schoors (2009), “Sovereign default and banking”, mimeo, University of Western Ontario.

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