Risky sovereign bond holdings by commercial banks in the euro area: Do safe assets availability and differences in bank funding costs play a role?

Commercial banks in some euro area member states hold large amounts of sovereign debt that offer a risk premium and hence higher yields than AAA-rated bonds issued by the most creditworthy countries. In particular, banks in vulnerable countries exhibit a bias towards domestically issued government bonds as de jure safe assets. We show that scarcity of the domestically available stock of de facto safe assets cannot by itself account for this home bias. Instead, we provide indications that differences in bank funding costs help explain the varying appetite of banks for relatively high-yielding (and hence riskier) government bonds at the expense of bonds issued by core countries governments or EU supranational entities, as banks match the return on their euro government bond portfolio with their own funding costs. In addition, prospects for a preferential treatment of domestic creditors in case of a public default and government pressure on banks to increase their holdings of government debt give incentives to hold domestic securities.