Reaching for Yield and the Diabolic Loop in a Monetary Union

One of the repercussions of the housing market collapse in the U.S. in 2007 was global anxiety about excess leverage, debt repayment, and overall credit conditions. Risk-pricing levels increased abruptly for highly indebted countries, making new borrowing to refinance debt increasingly difficult. Next year marks a decade since the eruption of the Eurozone sovereign debt crisis, when Greece, Italy, Ireland, Portugal, and Spain, known as the GIIPS countries, experienced an unprecedented rise in their borrowing rates.

For example, Greece and Ireland in 2010 ran an unprecedented peace-time deficit, reaching 15.8 percent and 32 percent of GDP, respectively. The Irish government bailed out its local banks and nationalized banks’ losses. Both countries were forced to ask for financial support from the IMF and the EU in May and November 2010, respectively. The Greek government offered billions of euros in government guarantees to its banks for two consecutive years, in 2008 and in 2009. In the Irish case, a government that had previously had one of the lowest levels of debt to GDP in Eurozone suffered a withdrawal of funding as markets became concerned about their debt repayment ability and the subsequent contingent liabilities involved in bailing out its insolvent banking system.

This deterioration in sovereign credit risk levels destroyed the balance sheet of domestic banks due to their large sovereign exposures (on this relationship see also the theoretical model of Gennaioli, Martin, and Rossi 2014). This vicious circle of banks hurting sovereigns and, in turn, sovereigns hurting banks is called the “sovereign-bank diabolic loop” puzzle, and the first empirical evidence of its existence was found by Acharya, Drechsler and Schnabl (2014).

Rarely has an economic concept faced such opprobrium as the diabolic loop puzzle, from researchers and central bankers to the political establishment and the European Commission, providing a major impetus for the creation of the European banking union.

It is – or at least it was until the financial crisis – common practice for banks to manage their liquidity by holding domestic sovereign bonds. While several researchers and policymakers investigated this topic, there was only one possible solution to this puzzle: a theoretical model, proposed by Fahri and Tirole (2018), in which local banks do not hold local sovereign debt because it is risky but instead invest in foreign sovereign debt, which is treated as risk-free. Yet, this solution is difficult to apply in real-world banking, given that it is questionable whether there is any risk-free sovereign debt.

In our new research, here, we provide a solution to the puzzle based on real-data empirical evidence: International spillovers generated by loosening U.S. monetary policy have an important effect on European economies through the “reach for yield” phenomenon, transmitted via the portfolio rebalancing channel. Our rationale relies on the theory that the incentives for banks to invest in riskier assets and to achieve higher yields increases significantly in a low interest-rate environment where banks have access to abundant liquidity. We introduce a macro-financial model where banks optimize their portfolios by investing in riskier assets, such as European sovereign assets, which have high default risk and yields. This, in turn, provides liquidity to the local banking system and mitigates the diabolic loop effect in the monetary union. This model finds strong support in real-world data and developments: The loosening monetary policy followed by the Federal Reserve, affected domestic US assets, resulted in a rebalancing towards non-U.S. assets, and in particular into European assets through an increase in banks’ risk-taking incentives. We show empirically that the expansion of the Federal Reserve’s balance sheet through quantitative easing (QE) reduces Treasury yields. This condition of low expected return contributes to a rebalancing of flows towards non-U.S. assets. We document an increase of flows towards European high yield assets, an outcome which can be attributed to the “reach for yield” incentive. We show that, when European governments adopt fiscal stimulus, this portfolio flow channel attenuates the effects of financial fragility in the domestic banking sector, and, as a result, euro area governments find access to funds to finance their deficit policies. Therefore, the “reaching for yield” incentive mitigates the diabolic loop effect.

REFERENCES

Acharya, V.V., Drechsler, I., Schnabl, P., 2014. A pyrrhic victory? Bank bailouts and sovereign credit risk. Journal of Finance 69, 2689-2739.,

Fahri, E., Tirole, J., 2018. Deadly embrace: Sovereign and financial balance sheets doom loops. Review of Economic Studies 85: 1781-1823.

Gennaioli, N., Martin, A., Rossi, S., 2014. Sovereign default, domestic banks and financial institutions. Journal of Finance 69, 819-866.

This post comes to us from professors Sabri Boubaker at University Paris-Est Créteil (UPEC), Dimitrios Gounopoulos at the University of Bath, Duc Khuong Nguyen at IPAG Business School, and Nikos Paltalidis at Durham University Business School. It is based on their article, “Reaching for Yield and the Diabolic Loop in a Monetary Union,” available here.