Sovereign Debt Holding and Bank Sensitivity toward Market Risk: An Alternative View of the Bank–Sovereign Problem

Government bonds have always been a popular type of investment for banks. However, this trend has been further enhanced by the provisions of numerous banking regulations aimed at promoting investment in these securities. We empirically test the role of the fiscal incentive provided by Polish authorities aimed at encouraging banks to invest in sovereign debt. Additionally, we verify whether and how increased sovereign debt holding has exposed banks to fair-value accounting and test the consequent market risk related to such investment. To this end, we use unique quarterly balance sheet data on sovereign holdings at Polish banks for the period from 2008:Q1 to 2017:Q4, organized in line with International Financial Reporting Standards (IFRS) as “available for sale,” “held for trading,” and “held to maturity.” Our regression results evidence that fiscal incentives greatly increase banks’ bias towards sovereign debt while reducing other investment. More importantly, our findings document that banks have enlarged the share of sovereign debt heavily exposed to market changes, primarily holding it under “available for sale.” Our stress tests document that a yield curve shock might leave less-capitalized banks with the shortage of regulatory capital. Our findings seem particularly important today, in the context of the COVID-19 pandemic, when the deteriorating fiscal situation of many countries may give a rise to a bond-yield shock and force banks to include potential losses in the regulatory capital.