REFILE-Euro zone 'doom loop' between government bonds, banks has weakened, study shows

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LONDON, Nov 10 (Reuters) - The linkage between sovereign bonds and banks that had left Europe’s financial sector vulnerable to debt-market selloffs has weakened in recent years, thanks to the ECB’s asset purchase scheme, a new study shows.

This so-called doom loop means a jump in sovereign borrowing costs puts a country’s banks at risk because they often hold a significant portion of the debt. Such fears emerged during Europe’s 2011 debt crisis and more recently amid the coronavirus-induced market panic of March.

But a summary of a study by Angelo Ranaldo, professor of finance and systemic risk at the University of St. Gallen, Jens Eisenschmidt, an economist for monetary policy strategy at the European Central Bank and Alexander Bechtel, research assistant at the University of St. Gallen, suggests this link has weakened as a result of ECB asset purchases.

The study, which is not yet publicly available, looked at credit default swap (CDS) spreads for governments and banks between January 2014 and December 2016. It concluded the “co-movement” between the two sets of credit risks had fallen by almost 80% since ECB began quantitative easing in 2015.

Before QE, “the sovereign-bank nexus was particularly strong for the periphery euro area (Greece, Italy, Ireland, Portugal, and Spain), rather than the core euro area,” Ranaldo told Reuters, referring to the likes of Germany, France and the Netherlands.

“After the (Public Sector Purchase Programme), the nexus in the periphery euro area decreased significantly, suggesting that QE mitigated this problem exactly in that area.”

Concern has centered in particular around Italian banks, which hold roughly 20% of the 2.1 trillion euros of outstanding government debt. Any sudden rise in yields, as in March, circles back to the balance sheets of banks holding the securities, in turn hurting their shares and CDS.

The March chaos was stemmed by the ECB introducing an emergency bond-buying scheme, which it plans to ramp up in December. The ECB’s 3.5 trillion-euro stimulus programmes have left it holding almost 25% of the Italian bond market -- a stake that is continuing to grow.

The research said QE -- which holds down borrowing costs -- mitigated any financial stability concerns generated by higher budget spending. It can thereby “alleviate the diabolic loop between sovereign and bank credit risk”.

“Our results highlight the importance of large-scale government bond purchases for financial stability, in particular during crises,” it added.