Moral suasion and bond buying in the Eurozone Crisis

Steven Ongena, Alexander Popov, Neeltje van Horen 17 March 2016



During the sovereign debt crisis, some important changes took place in European sovereign debt markets. First, Eurozone banks’ holdings of domestic sovereign debt more than doubled from their October 2008 levels, while holdings of foreign sovereign debt remained more or less stable. This increase was mostly due to actions taken by banks in Greece, Ireland, Italy, Portugal, and Spain. Second, after March 2010 only domestic banks in these countries increased their holdings of domestic sovereign debt, foreign banks instead reduced theirs.

These developments have led both academics and policymakers to speculate that the rapidly increasing exposure of domestic banks in stressed countries to their sovereign was not only due to increased incentives to hold domestic sovereign debt, for regulatory or risk-shifting reasons, but that is was also (at least partially) the result of fiscally stressed governments putting pressure on ‘their’ banks to purchase their own sovereign debt as demand by other investors was weak; behaviour referred to as ‘moral suasion’ (Acharya 2012, Michaelides 2014).1

The term moral suasion refers to an appeal to ‘morality’ or ‘patriotic duty’ to induce behaviour by the persuaded entity that is not necessary profit-maximising for it. This appeal can be combined with a threat of a more repressive regime such as, in the case of banking intensified supervision, a revoking of a bank’s license or limited access to central bank funding. However, it can also entail a natural collusion or collaboration between two parties that have an equal interest. For example, in the case of sovereign debt banks may choose to respond to pressure from their government if they are locked in a long-term relationship with the government where it is implicitly understood that current favours are always reciprocated in the future. Furthermore, supporting the government in times of fiscal stress reduces spreads on sovereign bonds directly affecting banks’ funding costs as well.

While a number of recent papers find evidence consistent with the occurrence of moral suasion (e.g. Battistini et al. 2014, Becker and Ivashina 2014, Acharya and Steffen 2015, De Marco and Macchiavelli 2015, Horvath et al. 2015), direct empirical evidence unequivocally showing that banks act in the government’s best interests when the government needs it most is still missing. In a new paper (Ongena et al. 2016), we take a decisive step towards identifying whether governments ‘morally sway’ banks to purchase domestically issued sovereign bonds in times of fiscal stress, and show that this indeed happened during the European sovereign debt crisis.

Identifying moral suasion

We employ a novel identification strategy that exploits salient characteristics of sovereign bond markets.

  • First, the main determinant of newly issued sovereign debt is the amount of maturing sovereign debt.
  • Second, the amount of maturing sovereign debt is strappingly pre-determined, because it is the outcome of choices typically made years ago by previous governments.
  • Third, because of these past decisions the government’s need to refinance maturing debt fluctuates substantially month-to-month.

As a result, total newly issued debt (the sum of roll-over debt and additional funding needs) also varies greatly on a month-to-month basis, both in normal as well as in crisis times, and the government has only limited ability to influence these monthly fluctuations when markets are stressed (Figure 1).2

Figure 1. Amount of sovereign bonds auctioned by the government of Italy, 2007-2013

We exploit these month-to-month fluctuations in governments’ financing needs and argue that if governments of fiscally stressed countries need to morally sway their banks, this should happen in those months where new issuance is high. Moreover, some banks are more likely to be morally swayed than others. The most obvious distinguishing characteristic is whether they are domestic or foreign-owned. Domestic banks are more vulnerable than foreign banks to explicit and implicit threats if they decide not to cooperate (Romans 1966, Reinhart and Sbrancia 2015). Furthermore, domestic banks have a stronger incentive to collude with the government when demand for sovereign bonds is weak, as an undersubscribed auction would increase sovereign spreads, which directly translates into higher funding costs for domestic banks as well.3

Our identification strategy therefore relies on assessing the differences in net purchases of domestic sovereign debt between high-need and low-need months during a period of fiscal stress for domestic banks (the treatment group) relative to foreign banks (the control group). We define a ‘high-need’ month to be a month in which the total amount of new debt auctioned by the domestic government is above the country-specific median for the applicable sample period. We focus on Greece, Ireland, and Portugal during the period May 2010 to August 2012, and on Italy and Spain during the period August 2011 to August 2012 (the acute phase of the crisis). Our hypothesis is that if the moral suasion channel is operational, domestic banks will be more likely than foreign banks to purchase domestic sovereign bonds during high-need months, while there should be no difference in behaviour between the two classes of banks during low-need months.

Employing proprietary ECB data which contain detailed end-of-month information on net flows and holdings of domestic sovereign debt securities for a large sample of domestic and foreign banks active in the peripheral Eurozone countries, we find strong and consistent evidence that moral suasion took place in stressed countries during the sovereign debt crisis.

Our analysis shows that during the height of the sovereign debt crisis, domestic banks were substantially more likely to purchase domestically issued sovereign debt than foreign banks in high-need months.

This effect is not only statistically significant but also economically relevant, i.e. it amounts to about half of the within-sample standard deviation of monthly purchases. This effect is stronger for state-owned banks and for banks with low initial holdings of domestic sovereign bonds, and does not appear to be fuelled by central bank liquidity provision. Moreover, our result is not driven by risk-shifting, carry-trading, regulatory compliance, or shocks to investment opportunities.

Policy implications

Our findings show that banks and sovereigns will collude in times of fiscal stress. This can help stabilise the system at a moment when many other players (i.e. foreign banks and insurance companies, asset managers, money market funds, etc.) are retreating from the market. That is, domestic banks can and do act as a ‘buyers of last resort’ for their sovereigns’ debt, limiting the stress by stabilising yields and spreads. This is especially beneficial when markets are overreacting, as it reduces the risk of self-confirming expectations.

However, this comes at a cost in that it reinforces the link between banks and their sovereigns in a period when sovereign bond spreads are already high. This increases the risk on the banks’ balance sheets, which in turn heightens systemic risk. To reduce this risk some change in regulation is warranted. An obvious first step is to reduce the chance that banks need to be bailed out by their governments. To this end, the introduction of higher capital ratios and the establishment of the European Banking Union with a common supervision and resolution system are important steps forward to break the sovereign-bank ‘doom loop’. Supervision at the European level will at the same time reduce the scope for moral suasion.

Yet, as long as governments to a large extent rely on their banks for their financing and banks have clear incentives to purchase sovereign debt for its favourable credit and liquidity characteristics and its use as collateral, common supervision and resolution will not be enough to break the sovereign-bank doom loop. Therefore, to reduce the potential disruptive effect of large holdings of (domestic) sovereign debt on banks’ balance sheets, a number of proposals for regulatory reform, which can complement the Banking Union, have been put forward.4 These include putting a positive risk weight on sovereign debt, which takes into account that sovereign debt is in fact – as has become clear during the sovereign debt crisis – not risk free. In addition, introducing an exposure limit similar to that applicable to holdings of other asset classes will limit exposures of banks to the sovereign. This would reduce the negative feedback loop and would increase banks’ resilience to sovereign risk. Finally, risk weights on all assets, including those on sovereign debt, could be allowed to vary with realised risk. These regulatory reforms should enhance banks’ incentives to take sovereign risk into account, increase banks’ resilience to such risk and limit systemic risk at EU-wide level, while at the same time allow banks to continue playing their market maker and stabilising roles in sovereign debt markets.


Acharya, V (2012), “Banking union in Europe and other reforms”,, 16 October.

Acharya, V, and S Steffen (2015), “The “greatest” carry trade ever? Understanding Eurozone bank risks”, Journal of Financial Economics 115, 215–236.

Battistini, N, M Pagano, and S Simonelli (2014), “Systemic risk, sovereign yields, and bank exposures in the euro crisis”, Economic Policy 29, 203–251.

Becker, B, and V Ivashina (2014), “Financial repression in the European sovereign debt crisis”, Harvard Business School mimeo.

De Marco, F, and M Macchiavelli (2015), “The political origin of home bias: The case of Europe”, University of Bocconi mimeo.

Horvath, B L, H Huizinga, and V Ioannidou (2015), “Determinants and valuation effects of the home bias in European banks’ sovereign debt portfolios”, Tilburg University mimeo.

Ongena, S, A Popov and N van Horen (2016), “The invisible hand of the government: “Moral suasion during the European sovereign debt crisis”, CEPR DP No. 11153.

Reinhart, C and M B Sbrancia (2015), “The liquidation of government debt”, IMF Working Paper WP/15/7.

Romans, J (1966), “Moral suasion as an instrument of economic policy”, American Economic Review 56, 1220–1226.


[1] See also and

[2] The correlation between the monthly volume of maturing and newly issued debt during the height of the sovereign debt crisis is 0.77.

[3] Funding costs of domestic banks are much more closely linked to the spread on sovereign bonds, compared to the funding costs of foreign banks present in the same country.

[4] See, for example, ESRB report on the regulatory treatment of sovereign exposures (March 2015) or  Acharya (2012).



Topics:  EU institutions Financial regulation and banking

Tags:  moral suasion, Debt crisis, Eurozone crisis, sovereign debt, fiscal stress, domestic bonds

Steven Ongena

Professor in Banking, University of Zurich and the Swiss Finance Institute; Research Fellow, CEPR

Senior Economist in the Financial Research Division, European Central Bank

Senior Economist, De Nederlandsche Bank and CEPR Research Fellow

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