EUROPEAN ECONOMYThe Sovereign-Bank Nexus in the Euro Area: Financial & Real Channels The Sovereign-Bank Nexus in the Euro Area: Financial and Real Channels  Mario Bellia, Ludovic Calès, Lorenzo Frattarolo, Andreea Maerean,Daniel P. Monteiro, Marco Petracco Giudici and Lukas VogelAbstractThe  sovereign-bank  nexus  played  a  key  role  in  the  2009-12  European  debt  crisis  by  enabling  pernicious  dynamics  whereby  governments  and  domestic  banking  sectors  mutually  enfeebled  each  other.  This  paper  reviews the direct (financial) channels and the indirect (real) channels through which banks and sovereigns interact,  and  that  can  give  rise  to  feedback  loops  between  the  two  sectors.  While  significant  progress  has  been  achieved  in  mitigating  the  direct  channel  of  the  loop  in  recent  years,  the  indirect  mechanisms  of  the  loop stayed largely intact. Policy options for improving the financial stability of both banks and sovereigns across  the  euro  area  have  been  discussed,  including  measures  to  increase  the  diversification  of  banks’sovereign debt holdings. Focusing on diversification as a standalone measure, a review of the literature and model-based  simulations  suggest  an  ambiguous  impact  on  systemic  risk.  However,  in  those  cases  where  diversification can either reduce total risks or keep them unchanged, it can also deliver an important shock-absorption  effect  in  crisis  periods.  In  such  cases,  simulations  show  that  higher  cross-border  integration  of  banking sectors would dilute the impact of asymmetric shocks across the regions of a monetary union, thus increasing the overall welfare of risk averse households.    JEL Classification:G01, G21, G28.Keywords: sovereign-bank loop, bank regulation, bailout, bail-in, SYMBOL, QUEST.Acknowledgements:The  authors  would  like  to  thank  Gabriele  Giudice,  Davide  Lombardo  and  an  anonymous referee for their useful comments.

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