Bank asset reallocation and sovereign debt

This paper examines how banks around the world have resized and reallocated their earning assets in response to the subprime and sovereign debt crises. We focus especially on the interaction between sovereign debt and the bank asset allocation process. After the crisis we observe a general substitution away from loans and in favor of securities. Our econometric findings corroborate that banks have readjusted the composition of their assets and the overall regulatory credit risk by substituting securities for loans. Banks, furthermore, have also been sensitive to those variables that are of direct interest to the regulator. The picture that emerges is a mutual protection pact regime, in which high-debt governments exert pressure on banks-- either through the regulatory system or through moral suasion-- to privilege the purchase of government securities over credit to the private sector in exchange for receiving protection against default.