In this project we would like to analyse the interplay of the risks arising from sovereign bonds in the banking system and the conduct of independent monetary policy. Although the banking union in the EZ is not completed, nor been put to test, yet, the institutional design promises the reduction of the bank-sovereign nexus (Breckenfelder/ Schwaab 2015) in order to break-up the “diabolic loop” (Schoenmaker 2014, p.3) of deteriorating banks’ balance sheets and rising public debt. However, the banking union can be only effective in that respect if and when the banking system is the starting point of that vicious circle.
The bank-sovereign nexus functions also the other way around: Due to the home bias sovereign bonds are over-proportionately represented on the balance sheets of the domestic banking system. Meanwhile more than 30% of outstanding global sovereign bonds display negative interest rates prominently featuring Japan and the Eurozone (DBb 2016, p. 14ff). A second trend is the rise in maturity of bonds and thus the expansion of maturity transformation by banks.
Accordingly, European banking systems accumulate increasingly both liquidity risks and interest rate risks. While the latter has a direct effect on the solvency of the banking system due to a depreciation or re-valuation of their assets in the course of future rising interest rates, the former is a result of the lock-in effect of their long-term maturities (DBb 2016). These risks are also mutually enforcing. Should the banking sector be inclined to sell their long-term, but low interest rate or even negative interest rate assets in an environment of increasing interest rates, the actual loss in value might overshoot the first-round depreciation squeezing their equity. In sum, under certain circumstances the banking system might be severely and systematically destabilised by government bonds in their balance sheets. Hence, central banks might face a trade-off in terms of existing QE programmes and rising interest rates. In addition, monetary transmission channels might turn out to be malfunctioning and thus restrict the central bank’s capacity to act.
As a starting point we recapture the current state of research on the banking-sovereign bond nexus, its risks for the financial system and its limits on the conduct of monetary policy. Here we will make use of existing-trilemma approaches. Aizenman et.al. advanced the classical trilemma of Robert Mundell (fixed exchange rates, liberalised capital flows, independent monetary policy) into a quadrilemma to include domestic financial market stability as one of four policy goals which might be in conflict to each other. Thus, with omitting fixed exchange rates and adhering to liberalised capital flows, instabilities from domestic financial markets might impede an independent monetary policy. To a similar conclusion comes the trilemma of monetary, financial and fiscal stability which is prominently used within the Trinity Research Network (Weidmann 2016). As an intermediate result of the first part we will identify the various domestic and cross-border channels within the EZ through which the bank-sovereign nexus deteriorates banks’ balance sheets and how monetary policy might be impacted.
In China similar problems exist as especially local communities due to infractructure projects accumulated partly unsustainable debt financed by investment funds which are owned by the commercial banking system. This is a drag on commercial banks’ balance sheets and might limit the scope of monetary policy in China.
In a second step we analyse current institutional settings and mandates of regulatory authorities in terms of enabling and empowering central banks and regulatory authorities to deal with the risks and then when risks materialise the negative balance sheet effects in the banking systems. Besides, we will also discuss several proposals and carve out their potential and shortcomings to deal with these risks in terms of mandate, instruments or financial means; this would include for instance an increase in capital requirements for government bonds depending on rating agencies’ evaluation, the introduction of Eurobonds or a fiscal backstop to prevent the rise in public debt from the very beginning (Schoenmaker 2014). Also in China regulatory changes were introduced and are planned to handle the problem of unsustainable debt especially by local communities financed via the shadow banking system. Especially as China aims at opening up its financial markets the interrelation between government bonds respectively public debt and the banking system has to be regulated to give monetary policy the necessary scope of intervention.
The third step would be semi-structured interviews with different financial actors which will address the interviewees’ evaluation of the institutional framework to address these risks. The interviewees shall be from Deutsche Bundesbank Frankfurt a.M. and Berlin, European Central Bank, Federal Ministry of Finance, Federal Financial Supervisory Authority (BaFin), Federal Agency for Financial Market Stabilisation (FMSA), altogether being members of the G-FSC and the ESRB, and the Finance Agency. Similar interviews with the Peoples Bank of China and supervisory institutions will be carried out in China.