Back in 2010 I wrote an FT Alphaville post called “Europe’s grim sovereign-bank loop.”

It was, to my knowledge, the first use of the term and one that has since been employed by many analysts, regulators and policymakers’ to describe the intermingling of Europe’s banking system with Europe’s sovereign debt crisis. Alastair Ryan and John-Paul Crutchley, then bank analysts at UBS, were the first to identify the trend of banks of using cheap financing from the ECB to buy and/or repo government bonds. This carry trade ultimately gave birth to the so-called sovereign-bank loop, in which the deteriorating fortunes of eurozone periphery governments weakened eurozone periphery bank balance sheets and vice versa. Four years later and it’s worth asking what happened to the loop?

Alastair Ryan, now an analyst at Bank of America Merrill Lynch, has a little update referencing Spanish banks.

In late 2008, following the change in the interest rates environment as a result of the financial crisis, Spanish banks started rebuilding their bond portfolios (ALCO) as a hedge for their nonsensitive sight deposit bases. The introduction of cheap LTRO money in late 2011 and the sovereign debt rally which started with Draghi’s OMT in July 2012 meant Spanish banks opportunistically expanded their bond holdings to a historic maximum of €567bn in June 2013, accounting for 17% of the system’s total assets. Since then, Spanish banks have reduced their bond holdings to €460bn, c. 19% below the peak, generating substantial trading gains along the way that have been used to clean up the legacy portfolio and prop up capital. Still, at 16% of total assets, the bond portfolio stands above the average level since the introduction of the euro (13%). Despite the regulators’ efforts to break the link between the banks and the sovereign, the Spanish banks stand as the second-largest holder of the Spanish government debt with 31% of the outstanding stock. At €270bn as of June 2015, they account for c. 60% of the banking system’s total bond holdings.

Ironically, a trade which once threatened the very survival of eurozone banks ended up being a healthy boost for their balance sheets following an almighty rally in peripheral eurozone debt. Now, as yields on Spanish government debt decline, the returns from the carry begin to ebb, theoretically creating new profit pressures for the banks.

There are plenty of levers banks can pull to offset those declining bond yields (simply selling the debt to help crystallize trading gains would be the obvious one) but it’s fun to check in on this still lively loop. BofAML analysts estimate that the Spanish banks they cover still generate a hefty 20 percent of their net income interest from their bond portfolios.

Europe’s grim sovereign-bank loop
Charting Europe’s grim sovereign-bank loop
How do you say vicious circle in Greek?