Issues surrounding banks’ home bias in sovereign debt have come to the forefront again during the Global Crisis, though there is an established academic literature in this area especially for equity home bias. Traditionally, home bias in banks’ holdings of domestic government debt has been linked to financial repression (see, e.g., Reinhart and Sbrancia 2011) that gives rise to directed lending to the government by captive domestic audiences such as banks and a tighter connection between government and banks. Fidora et al. (2006) showed that bond home bias is, on average, more pronounced than equity home bias with real exchange rate volatility explaining around 20% of the cross-country variation in equity and bond home bias. In contrast, Vanpee and Moor (2012) found a large dispersion of home bias between equities and bonds across countries and emphasised that driving factors of bond home bias clearly differed from those of equity home bias. In a similar vein, Portes et al. (2001) showed that government bonds responded less to information asymmetry between borrowers and lenders than corporate bonds or equity.
Recent studies on Eurozone countries highlight that fiscal space, changes in investor expectations on sovereign debt, and state ownership of banks have contributed to the increase in home bias. Findings by Cornand et al. (2014) suggested that fiscal space (measured by the ratio of debt on total tax revenue) – changes in investor expectations on governments’ debt sustainability (captured by shocks on sovereign 10-year bond spreads) – were key determinants to the home bias surge in a number of Eurozone countries during 2007-12. Furthermore, De Marco and Macchavelli (2014) showed that banks with a significant government ownership exhibited a higher home bias conditional on receiving liquidity injections by their governments. This effect is found to be more than twice as big for banks that were recapitalised by their European peripheral governments than for other European banks.
Drawing on our earlier VoxEU.org column (Asonuma et al. 2015b), here we examine some of the potential determinants of banks’ home bias in sovereign debt and provide some relevant empirical evidence.
Potential determinants of home bias
A key distinguishing feature of sovereign debt is that it generally enjoys preferential treatment relative to other financial assets in countries’ regulatory frameworks (see also IMF 2014). This feature underpins many of the factors that explain changes in banks’ holdings of domestic sovereign debt relative to all other assets. The impact of this preferential treatment is likely amplified during economic downturns. In addition, risk weights on other assets, including foreign sovereign debt, might differ significantly between countries which potentially could contribute to cross-country variation in home bias.
In the presence of financial sector vulnerabilities, domestic sovereign debt may become increasingly important as central bank collateral as well as for secured wholesale funding (BIS 2006). This includes more demanding liquidity requirements (e.g., the liquidity coverage ratio). At the same time, the supply of public debt may substantially increase during times of stress, including as a result of countercyclical fiscal policy. With the quality of other assets deteriorating, domestic banks will continue to absorb sovereign debt to safeguard the health of their balance sheets. In addition, private sector investment opportunities tend to decline during times of stress, further pushing banks towards domestic sovereign debt.
In addition to the favourable treatment of government debt in the regulatory framework, country authorities often take additional policy actions that support banks’ increased holding of government debt during times of stress. This could include liquidity extension to banks, and direct purchases of government debt or conditional commitments to purchase government debt by the central bank. While difficult to substantiate empirically, moral suasion is often used to ‘convince’ banks to purchase government bonds, especially in the primary market.
Cross-country variation in home bias could also be explained by factors such as the structural characteristics of the banking sector (e.g., excess liquidity), the type of institutional framework governing the financial sector, political stability, and institutional quality. Countries where the banking sector has a large deposit base (for example, because of the limited financial investment options available to households) and relatively limited investment opportunities are likely to have higher home bias. For example, in Japan where the banking sector is very large, corporates tend to rely on the equity market for financing rather than the debt market, limiting the portfolio options for banks.
Using a sample of advanced and emerging market economies, our empirical analysis confirms the importance of some of the above factors, for which data are available.1 We show that higher risk aversion measured by the VIX (reflecting increased uncertainty), higher debt-to-GDP ratio, and higher inflation (potentially capturing macroeconomic instability or signs of uncertainty accompanied by increased moral suasion) are associated with higher home bias. In contrast, private sector credit-to-GDP ratio (partly reflecting banks’ investment opportunities outside the government) and an indicator of institutional quality (capturing government stability and socioeconomic conditions) are significantly negatively related to home bias.
Disclaimer: This note draws on the main findings of a recent IMF (2015) board paper on “from Banking to Sovereign Stress: Implications for Public Debt”. The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the authors.
Asonuma, T, S Bakhache, and H Hesse (2015a), “Is Banks’ Home Bias Good or Bad for Public Debt Sustainability?”, IMF Working Paper 15/44 (Washington: International Monetary Fund).
Asonuma T, S Bakhache and H Hesse (2015b), “Is Banks’ home bias good or bad for public debt sustainability”, VoxEU.org, 5 April.
Bank of International Settlement (2006), “International Convergence of Capital Measurement and Capital Standards”, (Basel)
Cornand, C, P Gandre, and C Gimet (2014), “Increas in Home Bias and the Eurozone Sovereign Debt Crisis”, Working Paper GATE 2014-19.
De Marco, F, and M Macchiavelli (2014), “The Political Origin of Home Bias: the Case of Europe”, manuscript, Boston College.
Fidola, M, M Fratzcher, and C Thimann (2006), “Home Bias in Global Bond and Equity Markets”, ECB Working Paper No. 685.
IMF (2014), “Spain: Financial Sector Reform—Final Progress Report”, February (Washington).
IMF (2015), “From Banking to Sovereign Stress: Implications for Public Debt”.
Portes, R, H Rey, and Y Oh (2001), “Information and Capital Flows: The Determinants of Transactions in Financial Assets”, European Economic Review, Vol. 45; pp. 783–96.
Reinhart C and M S Sbrancia (2011), “The Liquidation of Government Debt”, NBER Working Paper No. 16893.
Vanpee R, and L D Moor (2012), “Bond and Equity Home Bias and Foreign Bias: an International Study”, Working Papers 2012/24, Hogeschool-Universiteit Brussel.
1 Recognising that the relationships between home bias and these factors may well reflect a two-way causality, lagged explanatory variables are used in the regression to address potential endogeneity issues.