The diabolic loop between sovereign and banking risk in the euro area

Abstract

Multiple interconnected channels link banks and governments: the sovereign-exposure channel (banks hold significant amounts of sovereign debt), the safety net channel (government guarantees protect banks), and the macroeconomic channel (bank and government health affect and is affected by economic activity). However, the sovereign-bank nexus in euro-area countries is particularly worrying since its member states issue debt in a currency they do not directly control and cannot ensure nominal repayment to bondholders. In this work, we summarise the main theoretical and empirical contributions that analyse this phenomenon and the legislative and institutional initiatives to reduce sovereign exposures in the banking sector.