Abstract
We analyze empirically the holdings of sovereign bonds by over 20,000 banks in 191 countries, and the role of these bonds in 20 sovereign defaults over 1998-2012. We document two robust facts. First, banks hold many government bonds (on average 9% of their assets) in normal times, particularly banks that make fewer loans and operate in less financially-developed countries. Second, within a country and during a default year, bank’s holdings of sovereign bonds correlate negatively with subsequent lending. Quantitatively, the average exposure to bonds is approximately associated with a 7-percentage point lower growth rate of loans relative to a bank holding no bonds. This negative correlation is stronger in defaulting countries that are economically and institutionally more developed. These results indicate that the “dangerous embrace” between banks and their government plays a key role in many sovereign defaults around the world, and its strength depends on local conditions.