“A reduction in the value of the bonds, in case of steep increases in yields, can lead to a hit to the balance sheet. Falls in asset prices also reduce the value of collateral that banks use... to obtain funds, adding to procyclical effects on funding.” Policymakers have begun discussing plans to address the problem, with possible options including imposing caps on the banks’ holdings of any one government’s debt, ending the risk-free assumption on sovereign bonds, stress testing sovereign exposures, or improving disclosure of holdings so private investors can better understand them. S&P’s analysts, however, believe that none of these changes are likely to happen. “We believe that meaningful reform is currently out of the question because disagreements among EU members are too strong,” the ratings agency said. If it did work, banks would diversify their investments – though €1.7 trillion of EU government bonds could be affected, and the fall in demand for the debt could push up state borrowing costs.
Europe is at risk of reigniting the so-called 'doom loop' that has damaged the Greek economy so enormously, as Europe's banks continue to buy more of their own government's bonds despite the huge exposures between states and financial institutions. S&P ratings agency warns that since 2008 the banks have doubled their holdings of their own states' debt, despite promises over the past five years to cut back on the exposures. The issue is that when financial institutions invest heavily like this on one government's debt, they become dependent on the government's good performance, and the governments in turn rely on the banks to purchase the debt; if this falters, the consequences are dire.