DP10661 | Determinants and Valuation Effects of the Home Bias in European Banks' Sovereign Debt Portfolios

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We document that large European banks hold sovereign debt portfolios heavily biased toward domestic government debt. This bias is stronger if the sovereign is risky and shareholder rights are strong, as evidence of a risk-shifting explanation of the home bias. In addition, the bias is stronger if the sovereign is risky and the government has positive ownership in the bank, as evidence of a government pressure channel. The home bias is positively valued by the stock market, as reflected by a positive association between the home bias and Tobin?s q. The home bias premium declines with domestic sovereign risk, but less so for highly leveraged banks, suggesting that both the risk-shifting and government pressure channels are operative. The European Central Bank?s large injections of liquidity in December 2011 and February 2012 reduced the marginal value of the home bias by allowing banks to expand their exposure to domestic government debt.