IF governments that dare to challenge their eurozone creditors need an example of what punishment awaits them they should look no further than Greek banks.

Since last month’s election of Syriza, which pledged to renegotiate the terms of Greece’s 172bn euros bailout, the country’s four biggest lenders have lost 38pc of their stock market capitalisation on average amid worsening deposit flight.

Benchmark government bond yields have increased 157 basis points, prompting renewed warnings of a Greek exit from the eurozone.

Investors worry over an increasing and potentially destabilising interdependency

In contrast to the 2012 crisis, wider contagion to other eurozone periphery countries has been muted — in part because expectations of bond buying by the European Central Bank, known as quantitative easing, has pushed sovereign bond yields to record lows.

But this has not stopped investors fretting over the increasing and potentially destabilising interdependency between the region’s financial institutions and its national governments, often referred to as the ‘bank- sovereign nexus’.

“Markets could get complacent at this point because the ECB QE programme is leaving so little on the table for investors, driving prices up and yields down,” says Bryan Wallace, a fund manager at JPMorgan Asset Management.

In recent years banks have boosted their profitability by using cheap ECB loans to buy domestic government debt offering a higher yield — a practice known as a ‘carry trade’.

An additional incentive is that holdings of sovereign debt do not incur any regulatory capital charge while, by contrast, loans to businesses would do.

The result is that, as of the end of last year, eurozone banks held a record 1.8tn euros in sovereign bonds, according to the latest ECB data, meaning a sharp rise in government borrowing costs would send a destructive ripple effect across the region’s financial institutions.

Government debt as a proportion of eurozone banks’ collective assets has increased nearly every month since the end of 2011 and is presently equivalent to 6pc of all banking assets, the highest proportion since the beginning of 2006.

The majority of these holdings are the domestic government bonds of a bank’s domicile.

Profits from the carry trade have eased pressure on banks to tackle their bad loans.

“Sovereign carry trades have allowed a significant number of eurozone banks that struggle with high volumes of bad loans to kick the can further down the road,” says Alberto Gallo, head of credit strategy at Royal Bank of Scotland. “In the medium term, or when QE ends, questions arise about their structural profitability. That is a major concern.”

Sovereign holdings are highest in the periphery. In Spain and Italy government bonds account for more than a tenth of collective banking assets, compared with 5.7pc and 6.2pc three years ago. In Portugal the figure is 8.1pc of banking assets, a rise of nearly 4 percentage points. By contrast Greece is one of the few countries where the proportion of government paper has fallen, from 9.6pc to 3.2pc.

“For now the carry trade is keeping everyone afloat,” says Mr Gallo.

Not everyone agrees that this matters.

Eurozone banks are better capitalised to withstand external shocks than they were in 2012. Last year they raised 82.6bn euros in loss-absorbing bonds and equity, including 37.1bn euros by periphery banks, a 150pc year-on-year increase from the year before, according to Dealogic.

Moreover, European banks have reduced their exposure to Greece specifically by more than 80pc to about 19bn euros since 2011-12 according to research by Morgan Stanley. The only way the sovereign-bank nexus would prove destructive is if other governments suddenly faced higher borrowing costs.

“We were more worried about the bank-sovereign nexus back in the last Greek crisis when the sovereign fundamentals were weaker,” says Mr Wallace. “The Spanish and Italian economies are slowly improving and that is helping the fundamental quality of the banks. The picture is diverging — Spanish and Italian banks are improving slowly while the situation at the Greek banks is getting worse.”

Jens Weidmann, the president of Germany’s Bundesbank, has repeatedly called for the debt of more troubled countries to be treated differently from the bonds of safer governments, to loosen the links between the lenders and their sovereigns. One way would be to require higher capital charges against the former. If anything, with QE poised to begin next month, the links are set to grow stronger.

Gildas Surry, a banks analyst at BNP Paribas, says: “Ultimately banks have to park their excess liquidity somewhere so they naturally look to the sovereign borrowings of their habitat.”

Published in Dawn, Economic & Business, February 16th, 2015

On a mobile phone? Get the Dawn Mobile App: Apple Store | Google Play