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FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust

A portfolio manager holds bonds of a sovereign whose debt is mostly held by domestic banks. Which feature of this holder structure most directly creates a 'sovereign-bank nexus' risk that can amplify a fiscal shock?

The sovereign-bank nexus arises because banks holding sovereign bonds suffer capital losses when bond prices fall. That weakens lending and growth, which further damages public finances and sovereign creditworthiness, creating a reinforcing loop between government and banking sector stress.

  1. ABank holdings of sovereign bonds mean that falling bond prices reduce bank capital, weakening credit supply and the economy, which in turn worsens public financesCorrect
  2. BDomestic holders always sell bonds at the first sign of stress, causing capital flight
  3. CDomestic holding eliminates the sovereign's rollover risk entirely
  4. DBanks holding sovereign debt face no mark-to-market exposure because bonds are risk-free

Explanation

The nexus is a feedback loop: sovereign stress cuts bond values, hurting bank balance sheets, which curbs lending and growth, which damages fiscal outcomes. Domestic holding may reduce but does not eliminate rollover risk, and sovereign bonds are not risk-free.

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