Occasional Research Paper - International Portfolio Frictions - 2025/1

Focus

Regulated financial institutions like banks and insurers have high demand for government bonds, for a variety of reasons. Yet the total supply of government debt in Europe, especially from countries with lower interest rates, is much smaller than the size of this segment of the financial sector. European insurance companies and pension funds (ICPF) and banks cannot all hold safe government bonds without pushing down the yields significantly, so they have to tilt their portfolios towards other securities, notably corporate bonds. This paper sheds new light on the global asset allocation of European banks and insurers.

Contribution

We use a new firm-level data set focusing on 31 European Economic Area (EEA) countries over 2016–21. These data give us insights into the portfolio decisions of European banks and ICPF. We also develop a model of fixed income portfolio decisions by regulated entities to explain that, in countries with a larger ICPF sector, the corporate bond share is higher in fixed income markets, and banks and insurers allocate a larger fraction of their fixed income portfolios to corporate bonds. 

Findings

We document five novel findings that cannot be easily explained by traditional international finance portfolio frictions. First, there is significant cross-country variation in insurers' and banks' portfolio allocations, even though banks and insurers across countries all have access to global capital markets and are all subject to pan-European regulations. Second, the composition of domestic fixed income markets, as measured by the share of corporate bonds in outstanding domestic fixed income instruments, is strongly positively correlated with the fraction of the overall portfolio invested in corporate bonds for both insurers and banks. Third, insurers and banks in high-interest rate and high-credit risk countries hold overall riskier portfolios. Fourth, the foreign portfolio composition of banks and ICPF resembles their domestic financial market characteristics. Fifth, multinational groups' local subsidiaries have similar portfolio allocations to other local insurers in the same market. These portfolio biases highlight the important barriers to European capital market integration, with consequences for monetary policy transmission across countries. And as there are important cross-sectoral spillovers, a multi-sectoral approach to regulatory design may be beneficial.