Home bias, sovereign-bank nexus and bank failure – Evidence from European stress tests

Abstract

This paper proposes a new way to clarify the relationship between the sovereign-bank nexus and an individual bank’s home bias by employing stress test data from Europe’s most important banks. We use the individual bank’s likelihood to fail in achieving a minimum capital ratio threshold as the dependent variable in a cross-sectional logistic regression approach and compute marginal effects. In further contrast to previous studies, we simulate the application of risk weights to sovereign exposure. We obtain three key findings: (1) Higher bank capital thresholds tend to render the impact of the home country’s default risk on bank failure insignificant. (2) Home country risk and home bias work in opposite directions with the latter often decreasing a bank’s failure risk instead of increasing it. (3) With simulated capital requirements for sovereign exposure, the failure risk-decreasing effect of a home bias is preserved if not strengthened.