Non-banks now central to sovereign-bank risk nexus, BIS finds

A new Bank for International Settlements (BIS) working paper reveals that the traditional sovereign-bank nexus has evolved to include non-bank financial institutions (NBFIs), forming a broader sovereign-bank-NBFI nexus.

The study, using European bank-level and global country-level data, finds that banks' direct sovereign exposures have recently become less significant in explaining the co-movement between bank and sovereign risk.

Conversely, banks' exposures to NBFIs have emerged as a crucial determinant of this co-movement, particularly when financial counterparties are located in high-risk sovereign jurisdictions.

This shift in risk transmission channels is also evident in aggregate data, highlighting a fundamental change in how sovereign risk propagates through the financial system.

The paper further documents that NBFIs' sovereign debt holdings are now important drivers of the co-movement between NBFI and sovereign risk, completing the triangular feedback loop.

The sovereign-bank 'doom loop' was a key vulnerability.

Post-crisis, non-bank financial institutions (NBFIs) significantly expanded their market footprint and interconnectedness with banks, introducing new risk transmission channels.

Many NBFIs engage in leveraged sovereign bond trading, often funded by short-term bank repo.

Sovereign risk shocks can severely impact NBFIs, triggering deleveraging and fire sales.

These actions transmit stress back to banks, which hold exposures to NBFIs, creating a triangular propagation mechanism that amplifies systemic risk across all three sectors.