No. 1166 - Banks' holdings of and trading in government bonds

In this paper we examine the holdings of government securities by domestic banks along with those of five other sectors: foreign banks, foreign non-banks, the official foreign sector, the domestic central bank and domestic non-banks. We use data for 21 advanced economies from 2004 Q1 to 2016 Q2. The results offer four main insights. First, banks are reluctant to undertake major changes in their holdings of domestic bonds but do accept frequent changes of more intermediate size. Second, the foreign official sector emerges as the clearest example of a contrarian investor, buying when prices fall and selling when prices rise. Third, the greater the holdings by domestic and foreign banks, the lower the yields tend to be on 10-year benchmark sovereign bonds. Finally, in all countries included in the sample we find a positive home bias in banks' sovereign holdings while foreign banks hold fewer bonds than predicted by a neutral portfolio measure. These results suggest that banks regard domestic government bonds as a special asset class (hence the positive bias and avoidance of major changes in inventories) which they manage in a flexible manner (hence the frequent intermediate changes and lack of systematic timing of transactions), in all likelihood to meet requests from their customers. All in all, this behaviour by domestic banks provides a positive contribution to the liquidity of the market.