(Bloomberg) — Euro-zone countries haven’t broken the link between public finances and banks that dominated the region’s sovereign debt crisis, and investors could refocus on that vulnerability next year, S&P Global Ratings said.
Despite the establishment of common supervision and resolution mechanisms aimed to eradicate such dangers, the entangled relationship that bred turmoil in several members of the single currency is “here to stay,” the company said in a report on Thursday.
“Problems in the banking sector can have devastating ripple effects on sovereigns, and vice versa — the so-called sovereign doom loop,” S&P analysts Nicolas Charnay, Cihan Duran and Karim Kroll wrote. “In light of weak economic growth, potential differences in the speed and magnitude of monetary and fiscal policies could bring the sovereign-bank nexus back under market scrutiny.”
Their study looks at how that link could amplify trouble in 2024 amid the impending confluence of recession risks, the reinstatement of European Union debt and deficit rules, and uncertainty on the outlook for interest rates.
One scenario reminiscent of the prior sovereign turmoil is where a country suffers a loss of market confidence over its public finances that correspondingly hurts its banks.
“Growing fiscal policy disagreements among EU member states could contribute to heightened market volatility and result in a loss of investor confidence in the worst case,” the analysts said. They cited UK turbulence in 2022 under former premier Liz Truss as an example.
Another scenario is where banks face drastically stronger headwinds amid an excessive return to austerity, and a third features the danger that monetary policy could be overly restrictive. Bank of Italy Governor Fabio Panetta warned of that risk earlier on Thursday.
While banks have cut their exposure to the public finances of their home countries, that was cyclical and is “unlikely to persist.” Increasing supply of government bonds, and existing rules and incentives for institutions will drive them to raise their sovereign debt holdings from an “already sizable” €2.3 trillion ($2.5 trillion) as of July, S&P said.
©2023 Bloomberg L.P.