Drawing on our earlier Economonitor column on home bias and public debt sustainability (Asonuma, Bakhache and Hesse, 2015), this blog briefly examines some of the potential determinants of banks’ home bias in sovereign debt. The favorable treatment of sovereign debt in the regulatory framework is sometimes complemented by policies that further support banks’ increased holdings of government debt. Empirical findings also suggest that factors that increase macroeconomic instability and uncertainty are associated with higher home bias, while better investment opportunities in the private sector, and better institutional quality are negatively linked to 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. This feature underpins many of the factors that explain changes in banks’ holdings of domestic sovereign debt relative to all other assets, i.e., banks’ home bias in sovereign debt. The impact of this preferential treatment is likely amplified during economic downturns. 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). 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 favorable 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. 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.
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, regression analysis confirms the importance of some of the above factors for which data are available. Recognizing 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. Results 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. Recent studies on the European sovereign-bank nexus find that the supply of government debt and governments’ ownership of banks also contribute to home bias in domestic sovereign bonds in the eurozone countries (see De Marco and Macchavelli, 2014.)
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, 2015, “Is Banks’ Home Bias Good or Bad for Public Debt Sustainability?” IMF Working Paper 15/44 (Washington: International Monetary Fund). Published as an Economonitor column here.
Bank of International Settlement, 2006, “International Convergence of Capital Measurement and Capital Standards,” (Basel)
De Marco, F., and M. Macchiavelli, 2014, “The Political Origin of Home Bias: the Case of Europe,” manuscript, Boston College.
International Monetary Fund, 2015, “From Banking to Sovereign Stress: Implications for Public Debt,”
Reinhart C., and M. S. Sbrancia, 2011, “The Liquidation of Government Debt,” NBER Working Paper No. 16893, (Cambridge: National Bureau of Economic Research).
 Based on a sample of advanced (AM) and emerging market (EM) economies, their findings suggest that home bias generally reduces the cost of borrowing for AMs and EMs when debt levels are moderate to high. A worsening of market sentiments appears to diminish the favorable impact of home bias on the cost of borrowing particularly for EMs. In addition, higher home bias is associated with higher debt levels, and with less responsive fiscal policy.