Banks, Government Bonds and Default: what do the data say? Discussion by Hélène Rey London Business School, CEPR and NBER Banque de France, 2012

The paper Motivation: “government default can endanger domestic bank stability” Determinants of bond holdings: Extract “bank specific” and “country specific” determinants of bond holdings; during sovereign crisis periods and in normal times Studies the effect of bond holdings on lending during default Data from Bankscope

Why do banks hold government bonds? Liquidity view: bonds used for collateral and to store liquidity Risk taking: search for yields in anticipation of and during crises Regulation in normal times and financial repression in crisis time In fact, paper is more about banks owning bonds of their own government (effect of default of their sovereign on lending).

Main results Bond holdings play a “key role” in crisis: banks have on average 13.6% of their assets in bond holdings (in sample with sovereign default) Bonds are accumulated during normal times mostly (87%). More bonds for banks in “less developed countries”; who “fund fewer loans; take less risk; are less levered”. During defaults, “larger and more profitable banks buy more bonds”.

Main Results Former set of results seen mainly as support for the liquidity view. Though the fact that during defaults, “larger and more profitable banks buy more bonds” is consistent with risk taking or financial repression view. Financial repression not really discussed (see Reinhart and Sbrancia (2011)) Second set of results: Causality statement: “Bond holdings have a significant effect on lending during crises” (-)

Data issues Do not observe country of the bonds. Use data as if all domestic holdings. Marked to market or book value? Maturity? Data “very close to IMF”? (Table 1) For 2010, Bankscope and stress test data should be identical (except for coverage) Yearly data: but during crisis holdings move very fast… Use interchangeably words “default” and “crisis”. Use a dummy for default.

Data issues Very limited sample for defaults: only emerging markets or poor countries (13 altogether) In 6 out of the 13 countries fewer than 3 banks…

On the motivation and the identification Isolating the “effect of government default on banking sector stability” seems hard Ireland, Spain, Iceland…: portfolio of banks caused problems in public finances Sovereign’s implicit or explicit liabilities towards the banking sector may be as important than the other way around. Example of LTRO: addressed liquidity issues in the banking sector, had an impact on bond holdings; joint dynamics of risk for banks and sovereigns

Endogeneity… Source: Shambaugh 2012

Interpretation of results? Rests on separation of a country component and a bank specific component (for both the fixed effect component: “normal time average” and the time varying component including default time). But it is plausible that large banks impact their country specific estimates, so that interpretation of the estimates are unclear. Could analyze separately large banks and correlations with country variables

Interpretation of results? Liquidity view versus regulation versus risk taking view, not clear cut For example, a bank may need a liquidity buffer and will seek liquid assets for which it does not have to post capital (interaction liquidity /regulation) After LTRO Italian and Spanish banks increased their domestic holdings of government bonds: was it because of risk taking? Or was it because of moral suasion? Or was it because they needed collateral accepted at the ECB?

Interpretation of Results? Second set of regressions studies how bonds holdings affect impact of default on loans Needs to control fully for variables driving both loans and bond holdings; determinants of loans other than bond holdings on the supply side; determinants of loans on the demand side; … Magnitude of the effect: elasticity of loans to bond holdings seem very high.

Other view: look at prices Acharya-Steffen (2012) regress bank stock returns on GIIPS bond returns Sample: January 2005- March 2012. Include LTROs. Find positive loadings on GIIPS bond returns and negative loadings with bund returns (correlated with ease of short term funding) Finds higher correlations for large banks, more leveraged banks, low Tier-1 ratios. Could be due to “carry trade”: long in risky bonds (would be consistent with risk taking hypothesis) But could also be due to macro factors affecting both bond spreads and stock returns

September 2011 June 2012

Conclusions Promising work on an important topic Many interactions (between sovereign, banks and growth) make causality analysis very tricky. Size of banks within a country Look forward to read the next version!