0:53:95

172:212:241 The Goldman Sachs Group, Inc. 165:165:165

115:153:198 7:133:73 139:195:70 246:127:38 190:50:50 Hyperlink 115:153:198 Institutions and the Crisis: A Few Reflections on the Sovereign-Bank Nexus

Florence, April 26, 2018

Francesco U. Garzarelli Goldman Sachs International Co-Chief Markets Economist +44 20 7774-5078 Global Macro & Markets Research [email protected]

Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S. ‘EMU Break-Up’ Risk Back to Pre-Crisis Levels Measures of EMU systemic risk, and sensitivity of selected EMU sovereigns

0:53:95 172:212:241 165:165:165 EMU Systemic Risk Has Returned Peripheral Spreads Are More Responsive 115:153:198 to Its Pre-Crisis Norms to Swings in EMU Systemic Risk 7:133:73 139:195:70 Selected measures of EMU systemic risk: SURE estimated coefficient - response of selected country GS, SENTIX and ECB spreads to a 1% increase of the EMU systemic risk variable 246:127:38 12

190:50:50 % bp 100 Hyperlink 115:153:198 GS - EMU Systemic Risk Variable 10

80 SENTIX Euro Breakup Index Basis Point Impact on 10y Country Spread 8 From Any 1-unit Movement in EMU Risk ECB Sovereign Systemic Stress Indicator 60 EMU Risk: Pre-Crisis Average 6

40 4

20 2

0 0 1997 2000 2003 2006 2009 2012 2015 2018 NET FIN AUS FRA BEL ITA SPA POR

Source: Bloomberg, Goldman Sachs Global Investment Research

Global Investment Research 2 EMU Rates: A Lasting ‘Stock Effect’ But ‘Flow Effect’ Lower ECB QE: ‘stock’ and ‘flow’ effects and PSPP gross purchases

0:53:95 0 172:212:241 -0.2 165:165:165 Reinvestments Counterbalancing -0.4 the Reduction in ECB QE Flows 115:153:198 -0.6 Our estimates put the 7:133:73 cumulative impact of ECB GS projections of the monthly ECB PSPP reinvestment profile -0.8 139:195:70 QE at around 50-80bp for -1 ECB Stock Effect the ‘core' markets 246:127:38 ('announcement effect' model): -1.2 2015 2016 80 190:50:50 2017 2018 EUR bn Net Government Bonds PSPP Purchases -1.4 and Government Bonds Reinvestments: Hyperlink 115:153:198 % 70 -1.6 Others - reinvestment Germany France Italy Spain 60 Netherlands - reinvestment France - reinvestment 0 50 Portugal - reinvestment -0.05 Spain - reinvestment 40 -0.1 Italy - reinvestment Germany - reinvestment -0.15 30 The QE ‘flow effects' PSPP Net Government Bond Purchases -0.2 have diminished over 20 Average ECB Flow Effect time but remain -0.25 ('announcement effect' model): economically significant 2015 2016 10 -0.3 2017 2018 -0.35 0 % Mar-16 Mar-17 Mar-18 Mar-19 Mar-20 Mar-21 Mar-22 -0.4 Germany France Italy Spain

Source: ECB, Bloomberg, European Commission, Goldman Sachs Global Investment Research, Global Markets Analyst: ECB QE Withdrawal Syndrome?

Global Investment Research 3 QE Has Boosted the ECB’s Forward Guidance GS estimates EONIA forward rates and their sensitivity to macro ‘surprises’

0:53:95 172:212:241 Since 2014, the Front-end of the EUR Swap Curve Has Net Purchases Have Reduced the Sensitivity of 165:165:165 Decoupled from Past Relationships with Macro Factors EONIA Rates to Macroeconomic Surprises 115:153:198 EUR 1-yr 1-yr forward swap rate and OLS fitted value (on OIS 1-yr1yr Rolling coefficient estimates of 1-yr EONIA 1-yr forward on index of 7:133:73 forwards swap rate, expected inflation and current ECB deposit rate) Euro area macroeconomic surprises (vs. Bloomberg consensus) 139:195:70

246:127:38 6 2.0 1.2 Coefficient 190:50:50 % % 5 1.5 1.0 Sensitivity to Macro Surprises: Hyperlink 115:153:198 EONIA 1y1y

4 1.0 0.8 ECB introduces ECB Negative negative rates Start of Start of Rates 3 ECB QE 0.5 0.6 ECB QE

2 0.0 0.4

1 Residual (RHS) -0.5 0.2 Actual 1y1y EUR Swap 0 Rate -1.0 0.0 Fitted 1y1y EUR Swap Rate -1 -1.5 -0.2 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2007 2009 2011 2013 2015 2017

Source: Bloomberg, Consensus Economics , Goldman Sachs Global Investment Research

Global Investment Research 4 Sovereign Risk Low But Responsive to Macro Outlook Italy and Spain 10-yr government bonds: overall valuations and macro factors

0:53:95 172:212:241 Spanish Bonds Have Outperformed ...Reflecting a Stronger Relative 165:165:165 Their Italian Counterparts Since 2016... Economic Outlook vs. Core Countries 115:153:198 Italian and Spanish 10y government bond yields: actual and 7:133:73 Contribution of macro/fiscal factors to our model estimates GS 'fair value' estimates. of 10y BTP-Bund spread and Bonos-Bund spread in bp. 139:195:70 250 80 246:127:38 bp 10Yr Italy-Germany Spread: Actual bp 230 70 190:50:50 10Yr Italy-Germany Spread: GS 'Fair Value' Estimate 10Yr Spain-Germany Spread: Actual 210 60 Hyperlink 115:153:198 10Yr Spain-Germany Spread: GS 'Fair Value' Estimate 190 50

170 40 Contribution of Macro/Fiscal Factors* To 10y Spread vs. 150 30 Germany: Spain Italy 130 20

110 10

90 0

70 -10 *EMU Spread Model: contribution of primary balance, debt/gdp and nominal growth differentials with Germany 50 -20 2014 2015 2016 2017 2018 2012 2013 2014 2015 2016 2017 2018

Source: Bloomberg, Goldman Sachs Global Investment Research

Global Investment Research 5 Bank-Sovereign Credit Loop Still at Play in Periphery EMU-4 Sovereign and bank CDS, and rolling 6-mth correlations

0:53:95 German SIFI Risk 172:212:241 Bank Equity Returns and Sovereign Risk Not Affecting the Sovereign 165:165:165 Still Co-moving in Peripheral Countries 350 115:153:198 bp Daily changes in sovereign CDS spreads and daily returns on equity 300 Germany Major Banks CDS 7:133:73 Spread (Average) financial index: 6-month rolling correlation 250 139:195:70 Germany Sovereign CDS 200 246:127:38 0.4 % - correlation 190:50:50 150 0.2 Hyperlink 115:153:198 100

0 50

0 -0.2 2005 2007 2009 2011 2013 2015 2017 Italy’s SIFIs Credit Risk Correlated -0.4 To Gyrations in Sovereign Risk

-0.6 Bank Equity and Sovereign 700 CDS Correlation: bp 600 -0.8 Germany France Italy Major Banks CDS (Average) 500 Italy Spain Italy Sovereign CDS

-1 400 2003 2005 2007 2009 2011 2013 2015 2017 300

200

100

Source: Bloomberg, Consensus Economics , Goldman Sachs Global Investment Research 0 2005 2007 2009 2011 2013 2015 2017

Global Investment Research 6 The Pricing of Sovereign & Bank Risk: Issuer Specific Systemic risk down, but credit differentiation is at play

0:53:95 172:212:241 165:165:165  Systemic, or ‘EMU break-up’ risk is back at pre-crisis levels. This reflects the business cycle, a counter-cyclical stimulus (negative rates, QE), and the upgrade to the institutional architecture (ESM, SRM etc.) – probably in that order. 115:153:198 7:133:73

139:195:70  Markets are differentiating among EMU issuers on the basis of macro fundamentals, particularly growth (see, for ex., the 246:127:38 pricing differential between Italy and Iberia, adjusted for liquidity). 190:50:50

Hyperlink 115:153:198  The ‘stock effect’ of QE (ca. 50-80bp on German 10-year Bunds) should remain in place for some years; national central banks will intervene in secondary markets at EUR 15-20bn/pm., with operational discretion.

 Nonetheless, EMU bond yields will rise on the back of a normalization of ECB policy rates, and spill-over effects from a rise in US rates.

 Fiscal interventions/ backstops have shifted the risk equilibrium in the banking sector of peripheral countries from ‘pooling’ to ‘separating’. This has encouraged the private sector to step into the NPL market.

 Until public debt is on a sustained downward trajectory peripheral banks will continue to trade with a higher cross-sectional correlation with sovereign risk – reflecting to the capital and funding channels.

Global Investment Research 7 QE Has Allowed Banks to Reduce Sovereign Exposure Commercial and central bank holdings of government bonds

0:53:95 172:212:241 Commercial Bank Ownership of Government ...As National Central Banks Have 165:165:165 Bonds Has Fallen Since 2015... Purchased More Debt Securities 115:153:198 7:133:73 Credit institutions holdings of government securities as ECB holdings of government debt, share of total assets, in selected countries % outstanding – at book value (excludes SMP holdings) 139:195:70

246:127:38

190:50:50 14 40% % Beginning of Hyperlink 115:153:198 Credit Institutions Holdings of ECB's QE 12 Gov.Securities (% of CI Total Assets): 35% 33% Issuer Limit Germany Italy 30% ECB Holdings of LT Government Debt 10 France Spain (% Outstanding - Book Value): 25% Germany 8 EMU Avg. US France 20% 6 Spain 15% Italy 4 10%

2 5%

0 0% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2015 2016 2017 2018

Source: Bloomberg, Goldman Sachs Global Investment Research

Global Investment Research 8 Similar ‘Home Bias’ Among SIFIs MFI and SIFI: breakdown of government bond exposure

0:53:95 German SIFIs Underexposed 172:212:241 ‘Home Bias’ Prevalent Across All EA Banks, Mostly to France and Spain 165:165:165 Especially in the Smaller, Weaker Ones 60%

115:153:198 GERMANY MFI’s holdings of domestic government debt as share 50% Share of EA Gov.Debt Portfolio by Country 7:133:73 (Systemic Banks): of total government debt portfolio Germany EA Debt Holdings (Systemic Banks) 139:195:70 40% ECB's Capital Key 246:127:38 100 30% 190:50:50 % MFI's Home Bias: 20% Hyperlink 115:153:198 90 Pre-Crisis (2007) 10% End-Crisis (2013) 80 0% Current Germany France Italy Spain Other EA 70 Italian Banks Need to Reallocate Towards ‘Core’ 60

70% ITALY 50 Share of EA Gov.Debt Portfolio by Country (Systemic Banks): 60% Italy EA Debt Holdings (Systemic Banks) 40 50% ECB's Capital Key 40% 30 Germany France Italy Spain Portugal 30%

20%

10%

0% Source: Bloomberg, Consensus Economics , Goldman Sachs Global Investment Research Germany France Italy Spain Other EA

Global Investment Research 9 The ‘Capital-Key’ Portfolio as the EA Risk-Free Bond ESBies, Concentration Risk Charges Regulation

0:53:95 172:212:241 165:165:165  Issue: EA banks should reduce ‘wrong-way’ risk exposure to domestic government bonds. This will (maybe) unlock EDIS 115:153:198 on the basis that risk reduction is required before any risk mutualisation. 7:133:73  Proposals: Sovereign Concentration Charges, ESBies: For both, the benchmark is a ‘ECB capital key’ portfolio. 139:195:70 246:127:38  ESBies: Long gestation, many thoughtful discussions, ECB QE portfolio could potentially be used to create volume. 190:50:50  Limitations: Hyperlink 115:153:198 o Underlying sovereign bonds are already liquid, and diversification benefits are disputed (underlying macro-economic correlation). o Uncertain ‘signalling effects’, and unclear behaviour in extreme stress events. o Italy is (conceptually) in the junior tranche, Spain is at the cusp. o A EUR 1.3trn worth of ‘safe assets’ (senior tranche of capital key portfolio, sized at 5% of total bank assets), the junior trance (@ 30% attachment point) would imply a EUR 500bn, almost twice the current size of EUR HY. o Potential market dislocations depending on the regulatory treatment of national bonds left out of the .

 Concentration risk charges approach looks like a more direct solution, note however that sovereign debt exposure is already subject to stress test (in the adverse scenario, EBA assumes 10% markdown on 10-yr BTPs), so a capital charge is already implicit (this also holds true for the 3% leverage charge).

 Open questions: o Where does the sovereign risk end up? Nonfinancial domestic private sector; foreign sector (i.e., somebody else’s problem)? o ‘Diabolic loop’ can be mitigated, not eliminated, if bank assets are largely domestic.

Global Investment Research 10 0:53:95 172:212:241 165:165:165 115:153:198 7:133:73 139:195:70 246:127:38 190:50:50 Hyperlink 115:153:198 Disclosure Appendix January 30, 2018

11 Disclosure Appendix

0:53:95 172:212:241 Reg AC 165:165:165 I, Francesco Garzarelli, hereby certify that all of the views expressed in this report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships. 115:153:198 Unless otherwise stated, the individuals listed on the cover page of this report are analysts in Goldman Sachs' Global Investment Research division. 7:133:73 139:195:70 Global product; distributing entities

246:127:38 The Global Investment Research Division of Goldman Sachs produces and distributes research products for clients of Goldman Sachs on a global basis. Analysts based in Goldman Sachs offices around the world produce equity research on industries and companies, and research on macroeconomics, currencies, commodities and portfolio strategy. 190:50:50 This research is disseminated in Australia by Goldman Sachs Australia Pty Ltd (ABN 21 006 797 897); in Brazil by Goldman Sachs do Brasil Corretora de Títulos e Valores Hyperlink 115:153:198 Mobiliários S.A.; Ombudsman Goldman Sachs Brazil: 0800 727 5764 and / or [email protected]. Available Weekdays (except holidays), from 9am to 6pm. Ouvidoria Goldman Sachs Brasil: 0800 727 5764 e/ou [email protected]. Horário de funcionamento: segunda-feira à sexta-feira (exceto feriados), das 9h às 18h; in Canada by either Goldman Sachs Canada Inc. or Goldman Sachs & Co. LLC; in Hong Kong by Goldman Sachs (Asia) L.L.C.; in India by Goldman Sachs (India) Securities Private Ltd.; in Japan by Goldman Sachs Japan Co., Ltd.; in the Republic of Korea by Goldman Sachs (Asia) L.L.C., Seoul Branch; in New Zealand by Goldman Sachs New Zealand Limited; in Russia by OOO Goldman Sachs; in Singapore by Goldman Sachs (Singapore) Pte. (Company Number: 198602165W); and in the United States of America by Goldman Sachs & Co. LLC. Goldman Sachs International has approved this research in connection with its distribution in the United Kingdom and European Union. European Union: Goldman Sachs International authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, has approved this research in connection with its distribution in the European Union and United Kingdom; Goldman Sachs AG and Goldman Sachs International Zweigniederlassung Frankfurt, regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht, may also distribute research in Germany.

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