The problem of the “sovereign-bank nexus” has still not been resolved nine years after the European sovereign financial crisis began. Far from it: the most recent results of the EBA stress tests show exceptionally strong home bias for Europe’s banks – which is even higher in the periphery than it is in core Europe. The preferential regulatory treatment for EU government bonds in bank balance sheets as well as the liquidity ratio requirements are causing increased demand for government paper. While the share of all outstanding government bonds held by domestic banks has fallen in recent years in most countries, with the exception of Italy and Greece, this is a result of high demand from the ESCB due to the PSPP. If the ECB decides to reduce its balance sheet in the medium or longer term, there is a danger of a shortage of demand for government bonds in the Eurozone. The risks of a diabolic loop caused by an exogenous economic shock are likewise ever-present.
While the core European countries would overwhelmingly welcome the introduction of rating-equivalent risk weights, the periphery states continue to resist. They fear higher capital requirements for their banks, competitive disadvantages for the financial sector versus core Europe and higher refinancing costs for the state. An end to preferential regulatory treatment for EU government bonds – even with the granting of a transition period that countries could use for structural reforms – is therefore unlikely in the foreseeable future.
However, a continuing “sovereign-bank nexus” harbours considerable risks for the Eurozone. Given secure demand from the commercial banks, financial markets are not putting any pressure on politicians in the periphery countries to tackle lasting structural reforms. The already pronounced economic divergence within the single-currency area threatens to go on widening, posing risks for cohesion and ultimately the unity of the Eurozone. One alternative would be a broad-based fiscal transfer mechanism, aimed at countering the centrifugal forces within the EMU. However, this would lead to economic dependencies while at the same time inhibiting the willingness to reform. In addition, such an option is unlikely to be backed by a political majority in the core countries – which would have to bear most of the financial burden.