Sovereign exposures in the Portuguese banking system

The euro area sovereign debt crisis exposed the linkages between banks and sovereigns and their adverse implications. In 2010, when sovereign spreads rose in several countries, tensions swiftly transmitted to the banking sector, uncovering the intertwining of banks’ and the respective sovereigns’ creditworthiness. Against a backdrop of already fragile fiscal positions, public finances in some countries were hampered by government support to banking institutions to avoid further systemic stress. These transmission mechanisms were reinforced during the crisis because, as sovereign distress intensified and led to loss of market access in some countries, banks substantially expanded their holdings of domestic sovereign debt. Such evolution was also observed in the case of Portugal. This paper provides a first attempt at uncovering the key drivers of the evolution of the exposure of the Portuguese banking system to the domestic public sector over 2008-2016.

This paper relies on an original dataset providing full coverage of banking sector bond and loan exposures to the domestic public sector. Focusing on banks operating in Portugal, these new data are used to assess how exposure to the public sector is created through either moral suasion, liquidity, or carry-trade. The analysis suggests strong evidence of moral suasion mechanisms, particularly in the most acute phases of the euro area crisis. Moreover, periods of increases in central bank funding seem to be associated with increases in holdings of sovereign debt securities, suggesting an appetite for an asset offering an attractive yield and that can be pledged as collateral (which would enable banks to obtain liquidity in times of trouble). Finally, weakly capitalised or less profitable banks do not appear to be more likely to be driven by carry-trade incentives in adjusting their sovereign exposures.

Click here to go to the paper by Maria Manuel Campos, Álvaro Pina, and Ana Rita Mateus.