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STS441 Giulio B. et al.
of time-varying bank and security fixed effects and appears stronger the
riskier the respective bond.
Our findings have important implications. First, they suggest that there is
a conflict of interest between banks’ own account trading and the asset and
wealth management services they offer to retail investors, potentially calling
for better consumer protection. The EU regulation Mifid II rolled out in January
2018, which requires trading prices for certain fixed-income instruments to be
published, might be a step in that direction. However, outstanding sovereign
2
bonds are subject to the new rules only if the initial size of the offering was
greater than ⁄1 billion, which is the case for only a small percentage of them.
At the same time our findings also show that the severity of fire-sale
contagion depends on the organizational structure of the financial sector.
Universal banks, i.e. bank holding companies that comprise, besides
proprietary trading, also asset management services for customers and asset
management companies, might mitigate fire-sale contagion and contribute to
3
a more resilient financial system. Third, these findings also suggest that
regulatory proposals suggesting a separation between bank proprietary
4
trading and other bank activities – such as the Dodd-Frank Act in the U.S. , the
5
6
Vickers Report in the U.K. , and the Liikanen Report in the EU – might
aggravate fire-sale contagion and lead to a more fragile banking system and
a more severe doom loop between banking and sovereign defaults. As a
consequence, with these institutional separations becoming effective, the
need for minimum capital requirements covering banks’ sovereign bond
holdings becomes even more pressing.
The remainder of our paper is organized as follows. In the following section
we discuss the related literature. Section 3 describes the institutional
background that led banks to large-scale sovereign debt sell-offs. In section
4 we present our data set, sample and main variables. Section 5 derives, from
a simple univariate analysis, first suggestive evidence of trading in risky
sovereign bonds between banks and their affiliated mutual funds, as well as
their retail customers. Section 6 uses a more sophisticated panel approach to

2 In a study of OTC secondary trades in corporate bonds in the United States, Edwards et al.
(2007) find that transaction costs are lower for bonds with transparent trade prices, and they
drop when the TRACE reporting system starts to publicly disseminate their prices.
3 It is interesting to note that, while these implications suggest that the opportunistic behavior
of banks has redistributional effects between bank owners and bank clients, they also imply
that the risky assets are immediately shifted to unleveraged market investors, which eliminates
the risk of further knock-on eff ects.
4 Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted on July 21, 2010.
5 Final Report of the UK’s Independent Commission on Banking from 2011, chaired by John
Vickers
6 Final Report of the High-level Expert Group on reforming the structure of the EU banking
sector, chaired by Erkii Liikanen and initiated by EU Commissioner Michel Barnier.
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