Bond selloff sparks euro crisis fears

EUROPE’S banks are heading into another period of uncertainty as rising government borrowing costs threaten to revive memories of the euro zone debt crisis that shook the region 15 years ago.

The latest bond market selloff is putting renewed attention on the links between governments and lenders, particularly in France, although stronger bank capital and tighter supervision could help contain the risks.

According to a recent Reuters report, investors and analysts are increasingly watching how long elevated bond yields will persist and whether pressure on government finances will eventually spill over into the banking sector.

While lenders are better equipped to absorb losses than they were during the previous crisis, they remain exposed to the financial health of their home countries.

“There is a limit to which you can insulate yourself from the domestic credit,” Simon Ainsworth, a senior banking analyst at Moody’s Ratings, tells the newswire.

“Banks come from a better starting point, but they are not immune,” he adds.

The concern comes as European bank stocks have fallen 10% over the past six weeks, five times the decline in the wider market, following a prolonged rally that had lifted the sector to a 16-year high.

Shares of France’s three largest lenders have dropped 17% over the same period.

France is at the centre of the latest market concerns.

Its borrowing costs have climbed to their highest levels in 25 years amid a large budget deficit, social unrest and the approach of the 2027 presidential election, with far-right and far-left candidates leading opinion polls.

The country’s position as the euro zone’s second-largest economy means sustained pressure on its public finances could have implications beyond its borders, particularly given the banking sector’s exposure to domestic government debt.

During the previous debt crisis, falling sovereign bond prices inflicted losses on banks holding government securities.

In some cases, governments had to bail out lenders, placing additional pressure on public finances and creating a damaging cycle between weaker sovereign balance sheets and fragile banks.

Bigger buffers

European lenders have since strengthened their defences through higher capital buffers, improved supervision and years of strong profits.

The European Central Bank (ECB) has also gained tools to intervene, while banking oversight across the bloc has been revamped.

Reuters’ analysis of European Banking Authority data shows that euro zone banks’ net holdings of sovereign bonds had doubled since the crisis, reaching €4.3 trillion (US$4.8 trillion) at the end of June.

However, banks’ capital buffers have grown even faster.

The ratio of sovereign bond holdings to capital available to absorb potential losses has fallen to below 2.5 times, from 2.7 times in 2013.

A lower ratio indicates that banks have more capital relative to their exposure to government debt.

For large French banks, domestic sovereign debt exposure is estimated at roughly 15% to 30% of their highest-quality capital, according to calculations by David Benamou, chief investment officer at Axiom Alternative Investments, and Aneeka Gupta, an equity strategist at WisdomTree.

That is considerably lower than the exposure of Italian banks during 2011 and 2012, when holdings of domestic government debt exceeded 100% of their capital, Gupta is quoted as saying by Reuters.

Nevertheless, falling bond prices can still create losses, particularly when banks need to sell securities to raise cash or adjust their accounting valuations to reflect market prices.

Government bonds have traditionally been treated as risk-free assets for regulatory purposes.

They help banks meet liquidity requirements and serve as collateral when borrowing from central banks and other lenders.

Proposals to remove their risk-free status or introduce limits on banks’ sovereign debt concentration have failed to gain traction so far.

However, the European Commission has identified greater diversification of sovereign bond portfolios as one way to strengthen the banking sector, with proposals expected in early 2027.

Losses under scrutiny

Banks have already reduced their reliance on domestic government debt, partly following pressure from the ECB.

Domestic bonds accounted for 41% of euro zone banks’ total sovereign holdings in mid-2026, down from more than 50% in 2013, Reuters’ analysis shows.

Lenders have also increased the proportion of bonds valued at cost to 60%, three times the previous level.

This accounting treatment allows banks to avoid recognising market losses on securities classified as financial assets held to maturity, provided they do not have to sell them.

The risk of forced sales has diminished because banks rely less heavily on short-term funding, Ainsworth says.

However, accounting treatment does not necessarily remove investors’ concerns about losses that have yet to be realised.

“If this is a temporary situation, it should not significantly affect investor sentiment.

“However, if it lasts over time, it could weigh on risk perception,” Morningstar DBRS analyst Maria Rivas tells Reuters.

The duration of the bond selloff could therefore become as important as the scale of the initial market move.

Persistent weakness in sovereign debt could affect how investors assess banks’ balance sheets, even if lenders do not immediately have to recognise losses.

Higher funding costs

Beyond their bond portfolios, banks face a more direct challenge from rising sovereign yields: the cost of raising money.

French banks are the European Union’s (EU) largest issuers of wholesale debt, leaving them particularly exposed when borrowing costs rise.

If yields remain elevated, refinancing existing debt will become more expensive and could gradually squeeze profitability.

WisdomTree’s Gupta says a permanently higher yield would raise French banks’ “cost of money every time they refinance, and that compounds”.

A former senior banking supervisor – speaking anonymously to Reuters – shares that assessment, pointing to more aggressive competition among banks for deposits as evidence of mounting funding pressure.

Greek bank Piraeus chief executive Christos Megalou expects further volatility in government bonds but does not anticipate a repeat of the previous crisis on the same scale.

Greece’s debt-servicing costs are now significantly below the average borrowing rates faced by Britain, he tells Reuters, marking a substantial change from the period when Athens was recovering from financial turmoil and multiple bailouts.

He also notes that France’s circumstances differ from Greece’s during that crisis.

“France is a very big economy and therefore has a lot of triggers to pull,” Megalou tells Reuters.

“The regulators, the policymakers, but also the banks, have battle-tested mechanisms to make sure that, most likely, we will not have a similar mega-problem again,” the chief executive adds.

“Obviously we are doing stress tests in our portfolio all the time.”