May 19, 2017 / 9:33 AM / 3 months ago

'Doom loop' link between European banks, sovereigns seen loosening

European Commission Vice-President Valdis Dombrovskis speaks about the future of the Banking Union in Brussels, Belgium, May 19, 2017.Francois Lenoir

BRUSSELS (Reuters) - The "doom loop" between European banks and governments is weakening and investors are gradually discerning between individual bank risk and sovereign risk, European Commissioner Valdis Dombrovskis said on Friday.

The loop occurs because banks hold sovereign bonds and when a sovereign loses market access -- as during the last debt crisis -- the value of bank portfolios fall dramatically and they need to get help from the government to stay solvent.

This increases borrowing pressure on the already stressed sovereign and further reduces the value of the bonds.

"The link between sovereigns and banks is indeed loosening," Dombrovskis told a conference on the European financial sector.

"Following an upswing during the crisis, banks now tend to hold fewer domestic government bonds. And we see positive developments in the price of bank bonds, which are starting to decouple from sovereign ratings," he said.

"Investors attach increasing importance to the standing of bonds among the hierarchy of banks' creditors compared to the rating of the associated Member State," Dombrovskis, commission vice president, said.

He said, however, that to make the financial sector more resilient to future shocks, the European Union had to complete its Banking Union project under which there is already a single supervisor for all euro zone banks and the same rules governing bank resolution, along with a fund to cover the costs.

"An important cornerstone, the European deposit insurance system, is still ahead of us," Dombrovskis said.

He also said that the bank resolution fund should get a common backstop in case it run out of money.

The euro zone bailout fund ESM is considered as the obvious choice for that role but opposition from Germany has so far prevented assigning it that role.

Reporting by Jan Strupczewski; Editing by Robert-Jan Bartunek

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