'Doom loop' tying European banks and governments reinforced

Mon Dec 16, 2013 3:22pm EST
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By Huw Jones

LONDON (Reuters) - European banks have filled their balance sheets with national debt since 2011, bringing them easy profits but reinforcing a "doom loop" linking weak banks to governments with shaky finances.

The euro zone debt crisis showed banks can suffer big losses from holdings of their own countries' bonds, which in turn can torpedo state finances if banks need to be bailed out.

Policymakers have been trying to loosen the mutual exposure of banks and governments that ensured they dragged one another down during the crisis.

But the European Banking Authority (EBA), the European Union's banking watchdog, said on Monday the share of bonds issued by sovereigns under stress held by their domestic banks had "increased markedly" between December 2010 and June 2013.

The net exposure of the leading banks to sovereign debt fell 9 percent in 2011 but then rose 9.3 percent to 1.59 trillion euros ($2.19 trillion) in the 18 months to June this year, data released by the EBA showed.

The data confirms what many already suspected - that banks, particularly in Italy and Spain, have been plowing cheap funds from the European Central Bank into buying more of their own countries' bonds, a lucrative carry trade that has also helped ensure governments can fund their deficits at sustainable rates.

Regulators partly blame a move by banks to rein in cross-border activity and build up new liquidity buffers made up predominantly of government debt as a way of reducing risk.

But the EBA's data - which updated core capital and holdings of sovereign debt and loans at 64 leading European banks - is likely to reinforce fears that the fortunes of the banks and the states in which they are based are still too closely intertwined.   Continued...

An illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in the late evening in Frankfurt January 8, 2013. REUTERS/Kai Pfaffenbach