Measures launched to support EU banks through the coronavirus pandemic could reinforce the sovereign-bank nexus that contributed to the sovereign debt crisis, according to Fitch, as banks increase government exposures in carry trades.
Fears over banks' exposures to their governments, the so-called bank-sovereign doom loop, came to the fore during the eurozone crisis, in particular in weaker economies.
Untangling the risk remains a challenge, and progress could be reversed by new crisis measures, said Fitch.
Seeking to support bank lending to businesses and households amid the pandemic, the ECB is offering banks loans at rates as low as -1% through its TLTRO III.
Meanwhile, EU legislators have increased banks' capital headroom through measures including relief on IFRS 9 accounting rules and the reintroduction of a prudential filter, which temporarily insulates banks' capital ratios from falls in the value of their sovereign bond portfolios.
Fitch expects some banks will - as with previous TLTROs - use the cheap funding to invest in even cheaper sovereign debt, encouraged by the capital relief measures and the postponement of the EBA's 2020 stress test.
This, the rater warned, will only reinforce the interconnectedness of banks and their sovereigns, as some lenders build larger exposures to their own governments.
As of the end of 2019, the gross carrying amount of general government exposures of EU banks was already at €3.08trn, Fitch said.
"Despite significant central bank intervention to dampen sovereign debt spreads, the risk of sovereign debt sustainability concerns spilling into the banking sector has risen," it said.
The rater said this trend will hinder regulatory initiatives to reduce the sovereign-banking nexus and limit taxpayers' exposure to the cost of rescuing banks that fail.
"The solvency of many banks will become more closely linked to the creditworthiness of their domestic sovereign as their sovereign exposure increases, both directly and through government guarantees on loans to help borrowers affected by the pandemic," said Fitch.
"A strong sovereign-bank nexus is generally not a problem for banks if the sovereign is strong. However, if a sovereign or its banking sector comes under financial stress, powerful adverse feedback loops can transmit risks between the two, potentially threatening financial system stability, as it did during the 2009-2012 eurozone sovereign crisis."
Mitigation measures - such as concentration limits or higher risk weights - are unlikely to be seriously considered until well after the coronavirus-related economic crisis subsides, said Fitch, due to their potentially destabilising effects.
Fitch estimated EU banks would have to rebalance €1.1trn of exposures to implement a single-name sovereign concentration limit of 33% of Tier 1 capital, suggested by the German ministry of finance.
Such a move is unlikely to gain traction while governments are preparing to issue unprecedented levels of debt, while regulators would also avoid any action that reduces banks' capital headroom, Fitch said.