Eurozone Fragmentation and Banking - Sovereign Nexus: An Integrated Empirical Analysis of Relapsing Systemic Risks (Rev-1.0)

Executive Summary

This report provides a multi-layered empirical analysis of the risk of relapse of financial fragmentation in the eurozone and the "doom loop" between the banking sector and sovereigns. Since the sovereign debt crisis between 2011 and 2012, the eurozone has significantly strengthened its institutional defence barriers. However, this analysis remains the #Eurozone fragmentation and banks-sovereign nexus: an integrated empirical analysis of rekindling systemic risks (Rev-1.1 Final) in the interaction of market dynamics, institutional design, and socio-political stability.

Executive Summary

This report provides a multi-layered empirical analysis of the risk of relapse of financial fragmentation in the eurozone and the "doom loop" between the banking sector and sovereigns. Since the sovereign debt crisis between 2011 and 2012, the eurozone has significantly strengthened its institutional defence barriers. However, this analysis empirically illustrates the remaining vulnerabilities as a result of the interactions between market dynamics, institutional design, and social and political stability.

The main conclusions of this report are as follows: First, at the heart of the vulnerability, there remains a "home bias" by banks, the so-called "home bias." This is structurally preserved as an unintended consequence of prudence regulations, continuing to closely link the fate of banks and sovereigns. Second, the eurozone is facing a "resolution trilemma." In other words, policy authorities are unable to simultaneously achieve three goals: 1) strict enforcement of loss burdens (bail-in) to creditors under the Bank Recovery and Resolution Directive (BRRD), 2) maintaining the stability of the financial system, and 3) strict compliance with state aid regulations. Previous cases have shown that financial stability and political considerations often outweigh the strict application of rules. Third, this analysis quantitatively shows that social and political divisions are a powerful factor that amplifies financial risk. Public repulsion against fiscal reconstruction has reduced the government's ability to implement policies and is directly woven into the sovereign risk premium. This means that there is a direct feedback loop between street protests and the bond market.

In conclusion, this report presents an integrated stress scenario where global shocks -- events such as serious dysfunction in the US Treasury market -- can overwhelm existing policy response capabilities by exploiting the mutually linked vulnerabilities of the eurozone. Although the resilience of the eurozone has improved, its defensive walls are unfinished, and its true value is being questioned under a new macroeconomic environment and geopolitical risks.

Section 1: Banks in the Eurozone - Anatomy of the Sovereign Nexus

1.1. Revisiting the Doom Loop: Propagation Path and Amplification Mechanism

The harmful feedback loop between banks and sovereigns, or "doom loop," continues to be a fundamental threat to the financial stability of the eurozone. This mechanism works primarily through four interlinked propagation pathways.

1. Bank Balance Sheet RouteBanks hold a large amount of their own government bonds, especially those. If sovereigns' creditworthiness decreases and government bond prices fall, a direct valuation loss occurs on the bank's balance sheet. This damages the bank's capital and raises concerns about its solvency.

2. Collateral routeGovernment bonds are the most important collateral assets in interbank markets and in funding from central banks. Downgrading government bonds and falling prices reduce collateral value and significantly constrain banks' financing capabilities. This could directly lead to a liquidity crisis.

3. Government guaranteed route: As the banking system shakes, expectations for implicit or explicit government relief will rise. However, financially vulnerable governments lack the ability to fully function safety nets, such as deposit insurance and capital injections. Loss of confidence in government guarantees increases the risk of deposits flowing, or bankrans.

4. Macroeconomic Path: The sovereign fiscal crisis forces austerity (tax increases and spending cuts). This significantly suppresses domestic economic activity and increases corporate bankruptcies and household defaults. As a result, the bank's financial situation will deteriorate further as the quality of its assets loaned and the number of bad debts increases.

These pathways interact and amplify negative feedback. The vicious cycle in which the sovereign crisis weakens banks and weakened banking systems further undermines their confidence in the sovereign is the essence of the Doom loop, a structural and continuous threat to the financial stability of the eurozone.

1.2. Empirical mapping of core vulnerabilities: Bank sovereign exposure

Empirically confirming the existence of the doom loop is the data provided by the European Banking Authority (EBA) risk dashboard. This data highlights the current state of so-called "home bias" how eurozone banks are deeply exposed (risk) to their country's sovereign debt.

Table 1 below summarizes the exposures of domestic sovereign debts held by selected eurozone banking sectors as of the first quarter of 2025. In particular, the ratio to equity (CET1) indicates the magnitude of the potential impact that fluctuations in sovereign debt prices have on bank solvency.

Table 1: Banking sector's home sovereign exposure in selected eurozone countries (Q1 2025)

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Source: EBA, retrieved 2025-09-14 (freq=Q, units=€ bn, %)¹

This data shows some important facts. First, banks in countries that have experienced sovereign stress in the past, such as Italy, Spain and Greece, still hold a large amount of their own government bonds, which amount to around twice their capital. A simple approximation of 5 years duration has a price effect of approximately -5%/100bp. The impact on CET1 differs depending on the book value/valuation category and whether or not hedges, so we will only illustrate the concept here. Secondly, banks from "core" countries such as Germany and France also own a considerable amount of their own government bonds, but their size is relatively small when viewed in terms of total assets and capital. Third, Ireland has managed to significantly reduce banks' dependence on their sovereigns after the crisis.

This home bias is deeply rooted by the structure of regulations, not just a market coincidence. The prudential regulation framework set forth by the Basel Committee on Banking Supervision (BCBS) has long been permitted to apply a 0% risk weight to its own sovereign exposure in its own currency in standard practice. This means that when banks hold their own government bonds, they do not need to accumulate capital. This regulatory incentive has provided a strong incentive for banks to hold their own government bonds, and has, as a result, laid the structural foundation for the Doom Loop. Although the introduction of positive risk weights and centralized levy levies to sovereign exposure has been discussed within the BCBS and the European Systemic Risk Board (ESRB), political resistance concerning the liquidity of the government's bond market and impact on fiscal finance has not been achieved, leading to drastic reforms.

1.3. Mitigation factors: Assessment of asset quality and equity fulfilment

Meanwhile, since the 2012 crisis, resilience in the eurozone banking sector has improved significantly. Data from the EBA risk dashboard shows an improvement in capital adequacy ratio and a significant decline in the Non-Performing Loan (NPL) ratio.

• Capital fulfilmentAs of the first quarter of 2025, the average common stock tier 1 (CET1) ratio for EU/EEA banks remains at 16.2%, a high level that is significantly higher than regulatory requirements. This means that the buffer to absorb certain shocks, including valuation losses on sovereign debt, is thicker than in the crisis.

• Quality of assetsBanks in particular in Italy, Spain and Greece have been largely disposing of bad debts over the past decade, and the NPL ratio has fallen to historic lows. This increases the bank's balance sheets' resistance to macroeconomic deterioration.

However, it is premature to believe that even with these improvements, the risk of the Doom loop has been completely eliminated. As shown in Table 1, in some countries' banking systems, the size of their national sovereign debt exposure still outweighs their capital. Therefore, in the event of a serious sovereign shock, even an improved capital buffer remains at the risk of erosion in a short period of time. The problem lies not in peacetime resilience, but in vulnerability to extreme tail events.

Section 2: Fragmentation as a Systemic Threat: Market and Economic Aspects

Financial fragmentation refers to a situation in the eurozone, a single currency zone, where the funding costs facing businesses and households differ significantly depending on the country of residence, and is a systematic threat that hinders the transmission of a single monetary policy and widens capital cost gaps within the region.

2.1. Real-time indicators of fragmentation: Sovereign spreads and TARGET2 imbalance

The most important real-time market indicators for measuring the progress of financial fragmentation are the imbalance between national government bond yield spreads and TARGET2, a payment system within the euro system.

• Sovereign spread: Using the yields on German government bonds (Bund) as the benchmark, the difference (spread) between the 10-year government bond yields in other eurozone countries directly reflects how the market rates the sovereign risks of each country. During the crisis between 2011 and 2012, Italy and Spain's spread with Germany expanded to above 500 basis points, fueling concerns about eurozone division. Spreads have shrunk significantly since the European Central Bank (ECB)'s powerful intervention, particularly since President Mario Draghi's "Whatever it takes" statement and the announcement of the last Outright Monetary Transactions (OMT) as a buyer), but they still fluctuate to reflect market tensions. The trend of spreads growing again in response to recent trends in interest rate normalization and increasing political uncertainty suggests that fragmentation is a stalemate.

• TARGET2 Imbalance:TARGET2 is a system that processes cross-border fund settlement within the eurozone. The net amount of debt and obligations held by national central banks (NCBs) in each country to the ECB is the TARGET2 balance, and the imbalance reflects capital flows within the eurozone. During the crisis of 2011-2012, massive private capital flight occurred from southern European countries to Germany. This outflow of private capital was filled by central bank money borrowed from the NCBs of Southern European countries, resulting in a massive debt (TARGET2 surplus) of the German Federal Bank to the ECB and a massive debt (TARGET2 deficit) of the Italian and Spanish banks to the ECBs. Therefore, the expansion of the TARGET2 imbalance at the time was a clear signal indicating capital flight and the aggravation of financial fragmentation.

Care must be taken when interpreting these indicators. After the launch of the Quantitative Easing (QE) programme by the ECB since 2015, the TARGET2 imbalance has grown again, but the main factor was not capital flight, but technical, asset purchase settlements were primarily made through German financial institutions. Therefore, in situations where technical factors like QE are not in the background, the rapid expansion of the TARGET2 imbalance coinciding with the expansion of sovereign spreads should be interpreted as an extremely dangerous signal indicating a rekindling of serious capital flight in the 2012 model.

2.2. Transmission to the real economy: credit contraction and deposit outflow

Financial fragmentation is more than just a problem with financial markets. It has a serious impact on the real economy through its credit channel.

• Credit status: As sovereign risk increases, banks in the country face damage to their balance sheets and rising funding costs, hardening their lending attitudes. The ECB's quarterly Bank Lending Survey (BLS) clearly illustrates this mechanism. During the crisis in 2012, Italian and Spanish banks significantly tightened lending standards for businesses and households compared to German banks, which contributed to the serious economic downturn in both countries. The expansion of sovereign spreads will directly lead to rising borrowing rates for domestic businesses and households and a tight credit stump, blocking the effects of the ECB's accommodative monetary policy.

• Deposit flow: As fragmentation becomes more severe and concerns about the health of their banking system grow, depositors will move funds to banks in countries that are considered safer. This causes deposit outflows, also known as "quiet banks." Financial institution balance sheet statistics published by national central banks are an important data source for tracking the inflow and outflow of deposits from households and non-financial corporations during times of crisis. In 2012, significant deposit outflows were observed in Greece and Spain, further straining bank liquidity and exacerbating the Doom loop. This trend in deposit flows is an indicator that should be monitored very closely as a barometer of confidence in the financial system.

Section 3: Eurozone Institutional Gauntlets: Defenses and Defects

In response to the sovereign debt crisis, the eurozone has created a complex institutional framework to address systemic risk. However, this framework encompasses fundamental tensions surrounding fiscal discipline, bank resolution and the role of central banks, and is inherently vulnerable.

3.1. Financial backstop: Stable and Growth Agreement (SGP) and its political limits

The foundation of the eurozone's fiscal discipline is the stability and growth pact (SGP). The SGP requires member countries to keep their fiscal deficits within 3% of GDP and their government debt balances within 60% of GDP. The rules aim to prevent excessive fiscal deficits from causing negative ripple effects on the entire monetary union.

However, the operation of the SGP has always faced political challenges. The application of strict rules will deprive countries of discretion, particularly during recession, making it difficult to implement anti-cyclical fiscal policies. Therefore, in response to serious economic shocks such as the COVID-19 pandemic, the "general escape clause" was invoked and SGP rules were temporarily suspended. The existence and invocation of this clause indicates that SGP is a framework that is flexibly operated by political judgment, rather than rigid rules.

SGP rules have been reapplied since 2024, but many member states have far surpassed the 60% standard in debt levels as a result of their response to the pandemic and energy crisis. Eurostat data shows that debt ratios in Italy, Greece, France and Spain remain below 100%, and these countries will be subject to continued fiscal reconstruction pressure under the SGP in the future. This demand for fiscal reconstruction is a spark to social and political tensions, which will be discussed later, and in itself creates a paradox of increasing sovereign risk.

3.2. Loop cutting: the reality of Bank Rehabilitation Resolution Directive (BRRD) and the state subsidy

A central institutional reform to break the doom loop is the introduction of the Bank Recovery and Resolution Directive (BRRD). The heart of BRRD is that it has established the "bail-in" principle in which bank shareholders and creditors are responsible for the losses, instead of taxpayer bailouts. This aimed at internalizing the costs of bank bankruptcy and cutting off the burden on government finances.

However, the strict application of BRRD creates complex tensions with the EU's state aid regulations. State Aid rules generally prohibit government support for certain companies from distorting market competition. Injecting public funds into banks is highly likely to violate this rule.

The real-world operation of this institutional framework is illustrated by two contrasting cases.

{Case A: Banco Popular (2017)—Pure treatment}

This case is considered a "pure" resolution in which BRRD functions as intended. After being recognized by the European Central Bank (ECB) as "failing or likely to fail," the bank was then sold to Santander Bank for 1 euro, under the decision of the Single Resolution Board (SRB) when shareholders and subordinated creditors were completely bailed out of the losses. During this process, no public funds or funds from the Single Resolution Fund (SRF) were put into use, and no issues with State Aid regulations were raised.

Case B: MPS (2017)—Exception recognition and national aid

This is a more complicated case. The bank was found to have a capital shortage after a stress test, but was judged to be "solvent (they are able to pay)." This led the Italian government to inject public funds using the BRRD exception provisions called "precautionary recapitalisation." The measure circumstanced a stake in the losses (Baden sharing) to subordinated creditors while avoiding complete resolution. The European Commission has approved this under State Aid Rules as a measure to avoid serious economic disruption.

These cases highlight the "resolution trilemma" that the eurozone faces. Policy authorities can only achieve two goals simultaneously: 1) strict bail-in under the BRRD, 2) maintain stability in the financial system, and 3) adhere to State Aid regulations. The European resolution framework, not the usual domestic bankruptcy proceedings, is only applicable if the Single Resolution Committee (SRB) determines that the resolution is "in the public interest" for the purposes of maintaining financial stability (Public Interest Assessment (PIA). Furthermore, the use of a Single Resolution Fund (SRF) is subject to a preliminary loss burden (bail-in) by shareholders and creditors, which in principle corresponds to 8% or more of the bank's total liability. In the case of Banco Popular, ① and ③ were given priority, while in the case of Monte dei Paschi, ① was only partially applied to prioritize ②, and ③ was overcome by exception provisions. These cases suggest that in the event of a large systemic crisis, maintaining financial stability (2) is likely to be the top priority, with flexible interpretation of rules and exceptional public support likely.

3.3. ECB as the last bastion: From OMT to the transmission protection mechanism (TPI)

The last bastion of eurozone's institutional defense is the ECB's crisis response tool. The ECB's actions are strictly constrained by Article 123 of the TFEU (Treaty on the Functioning of the European Union), which prohibits direct fiscal financing to member state governments, and Article 125, which is a "no-bailout clause" that prohibits relief between member states. The ECB's crisis response tools are designed with the aim of protecting monetary policy transmission mechanisms while complying with these legal constraints.

• Flexible reinvestment in PEPP: The plan is to concentrate reinvestment of bond redemption funds purchased through the Pandemic Emergency Purchase Programme (PEPP) in government bonds in a particular country when the government bond market is exposed to tension. This is positioned as the primary line of defense to combat fragmentation. PEPP has the flexibility to allow divergence from the capital keys of each country than the traditional Public Sector Purchase Programme (PSPP).

• Transmission Protection Instrument (TPI): A more powerful backstop introduced in July 2022. TPI allows government bonds from certain countries to be purchased in the secondary market to counter the "unfair and disorderly market dynamics that seriously threaten the transmission of monetary policy." Purchases under TPI will focus on public sector securities with a remaining period of one to ten years. The invocation of the TPI is at the discretion of the ECB Board, but the following criteria will be cumulatively considered in determining their eligibility⁶:

  • 1. Compliance with the EU fiscal framework: Not subject to the excess fiscal deficit procedure (EDP).

  • 1. The absence of serious macroeconomic imbalances: Not subject to the Overimbalance Procedure (EIP) and not rated as failing to take corrective action.

  • 1. Financial sustainability: Public debt is determined to be sustainable based on analysis by the European Commission, the European Stability Mechanism (ESM), the International Monetary Fund (IMF), etc.

  • 1. Healthy and sustainable macroeconomic policy: Complying with commitments set forth in the Reconstruction and Resilience Facility (RRF) and country-specific recommendations in the European semester.

These standards are intentionally left ambiguous and give the ECB great discretion. However, at the same time, this means that the activation of the TPI will be a highly political decision rather than a purely technical decision. Determining whether a country's financial situation or policy meets the criteria is heavily influenced by the political dynamics between the European Commission and member states. Therefore, while the ECB plays a last bastion of financial stability, it is placed under structural constraints of technological neutrality and political discretion.

Section 4: Social fault lines: fiscal reconstruction and political risks

Financial markets and institutional frameworks do not exist within a vacuum. They are deeply defined by social stability and political dynamics. In the eurozone, the demand for fiscal reconstruction often leads to social backlash, which creates political instability and ultimately forms a negative loop of increasing the sovereign risk itself.

4.1. The price of stability: austerity, social unrest, and sovereign risk premium

Requiring fiscal reconstruction under SGPs often involves austerity, which inflicts pain on the public, such as spending cuts and tax increases. This directly leads to an increase in social unrest. Event datasets such as the Armed Conflict Location & Event Data Project (ACLED) and the GDELT project allow for quantitative tracking of the frequency and intensity of social anxiety events such as strikes, demonstrations and riots.

Analyzing data from Greece, Spain and Italy from 2010 to 2015 shows a strong positive correlation between a period when government interest payments (to GDP) rose sharply and financial pressure was at its peak, and when social unrest events occurred. This empirical evidence suggests that financial market stress directly undermines social stability through the pathway of austerity.

This relationship is not one-way. Social unrest is itself a factor that increases sovereign risk. Financial markets assess not only the level of debt of a government, but also the ability and willingness of the government to politically and socially implement fiscal reconstruction measures necessary to repay the debt. Large, sustained social unrest causes serious doubts about governments' ability to implement policies, prompting investors to demand a higher risk premium. In other words, the intensification of street protests directly bounces back to government funding costs, in the form of rising government bond yields. In this way, a self-amplifying feedback loop is formed between the social class, institutional class (fiscal discipline), and market class (sovereign spread).

4.2. The impact of political fragmentation on market trust and institutional cohesion

Social unrest encourages political fragmentation. Frustration with austerity has diminished support for existing mainstream parties and prompted the rise of populist and euroskeptic parties. This political division exacerbates the doom loop in a double sense.

First, its impact on the market. Market uncertainty increases as political instability increases and future policy foreseeability decreases. In particular, when the likelihood of an administration coming into question the eurozone framework and commitment to fiscal discipline increases, investors will be demanding additional risk premiums from the country's sovereign bonds, which incorporate the risk of redenomination of the currency.

Second, its impact on the system. The eurozone's crisis response capabilities rely on political cohesion and cooperation among member states. Important institutional reforms, such as the completion of banking alliances (particularly the establishment of the European Deposit Insurance Scheme (EDIS)) and SGP reforms, require consensus building between member states. However, as domestic political divisions deepen in each country, the movement to prioritize national interests will be strengthened, making it difficult to compromise and cooperate for the interests of the entire eurozone. This will slow the strengthening of the eurozone institutional defense barriers and increase system-wide vulnerability.

Section 5: Integrated Stress Scenario Analysis and Strategic Implications

The final section of this report combines previous analyses and presents a forward-oriented stress scenario to assess the systemic risks facing the eurozone. This scenario is not a prediction, but rather shows the logical consequences of possible situations when identified vulnerabilities are chained together.

5.1. Eurozone version of "Walpurgis"? : A chain of bankruptcy points in a new crisis

The starting point for the analysis is to envisage the occurrence of serious risk-off events in global financial markets. This could be an exogenous shock, such as a serious dysfunction in the US Treasury market, as depicted in the analytical material "Walpurgis" scenario provided. Below we will detail how this shock spreads through the three interlinked layers of the eurozone (markets, institutions, and society) and tests existing defensive barriers.

1. Initial shocks in the market: A global "escape to quality" begins, investors sell risky assets and move funds to the safest assets. This will cause the yields on German government bonds to fall sharply, while sovereign spreads in neighboring countries such as Italy and Spain, which are considered financially vulnerable. This spread expansion hits the balance sheets of banks in these countries and immediately creates a huge valuation loss through the large domestic sovereign exposures analyzed in Section 1.

2. Dysfunction in the institutional class: The ECB's first line of defense, TPI, will be tested. However, if the country that epicenter of the shock does not fully meet SGP standards and is also behind in structural reforms, political conflicts will arise within the ECB board over the invocation of the TPI. Some "hawks" countries are concerned about moral hazard and oppose intervention without strict conditionality. Panic is accelerated as market observations that TPI will be delayed or limited. At the same time, one of the major domestic banks will suffer a serious capital shortage, resulting in the need for resolution. The "trilemma of resolution" discussed in Section 3 here becomes a reality. To prevent systemic transmission, senior creditors and large depositors need to be protected, but this is contrary to the principles of the BRRD and is difficult to obtain approval from other member states under State Aid Rules. They have fallen into an institutional dead end and are unable to respond promptly and decisively.

3. Amplification in the social classFaced with market pressure and demands from the EU, the government is forced to launch a radical austerity package to restore market confidence. This immediately causes social unrest such as large-scale protests and strikes, as analyzed in Section 4. Social turmoil develops into a political crisis, coalition government collapses, and parliament is forced to dissolve.

4. Final Feedback Loop: The occurrence of a political blank will decisively ensure that "sound and sustainable macroeconomic policies" which are prerequisites for the activation of TPIs will not be met. The ECB loses its basis for intervention, and the market realizes that the last bastion will not work. The sovereign spreads will skyrocket to uncontrollable levels, and the government bond market will effectively close. This will cause the entire domestic banking system to fall into a solvency crisis, and deposit outflows will accelerate. Here, a Doom loop, which is larger than the 2012 crisis, is completed, and the Eurozone enters an out-of-control systemic crisis.

5.2. Strategic Implications for Surviving Rekind Fragmentation

This stress scenario shows that the eurozone defense barrier remains incomplete and can break down if multiple vulnerabilities are manifested simultaneously. From this analysis, the following higher order strategic implications are derived:

• Implications for policy authorities：

  • Completion of the Banking Alliance: In breaking the chain of risk, the completion of a banking alliance, including the establishment of a European Deposit Insurance Scheme (EDIS), remains the most important issue.

  • Reform of fiscal rules: There is a need to reform SGP into a more realistic, politically viable framework that promotes sustainable growth and enables counter-cyclical fiscal policies, not just strict numerical targets.

  • Clarifying the role of the ECB: It is essential to form clearer political consensus in advance that reduces political ambiguity around the criteria for invoking the TPI and allows the ECB to act quickly within its mandate.

• Implications for institutional investors：

  • Building an integrated risk model: It is urgently necessary to create an integrated sovereign risk assessment model that incorporates political risk and social unrest indicators as quantitative inputs into traditional economic and financial models. Data sources like ACLEDs should no longer be supplementary information and should be at the core of risk assessment.

  • Stress test for institutional bankruptcy points: Portfolio stress testing should not only take into account the rise in market volatility, but also institutional collapse scenarios such as "TPI not invoked" and "BRRD not applied for political reasons."

  • Breaking the trap of regulation:Recognizing that regulatory preferential treatments such as 0% risk weights do not reflect true risk, we should proceed with strategic diversification from overly concentrated sovereign exposures, within the limits that the regulations allow.

In conclusion, the eurozone has learned much from past crises and has strengthened its system. However, the fundamental dynamics of the Doom Loop still exist, and the threat is reshaping and rekindling due to new macrofinancial environments and social and political rifts. The next crisis is likely to manifest not as a pure economic or financial crisis, but as a hybrid crisis that involves a complex intertwining of markets, institutions and societies. That preparation is not yet sufficient.

footnote

¹ Created based on data obtained on September 14, 2025, from the European Banking Supervisory Authority (EBA) "Risk Dashboard Q1 2025 Statistical Annex" (e.g. Chart 1.14 'Sovereign Exposures', Chart 1.6 'Capital Adequacy'). Public data from EBAhttps://www.eba.europa.eu/risk-and-data-analysis/risk-analysis/risk-monitoring/risk-dashboardAvailable at. The formula for "Our country exposure / CET1 capital (%)" is (Our country sovereign exposure) ÷ (CET1 capital) x 100.

² The ECB analysis points out that the expansion of the TARGET2 imbalance after the initiation of quantitative easing (QE) is primarily technically attributed to the settlement structure of asset purchases, and is essentially different from capital flight during a crisis. ECB Financial Stability Review, May 2017, Box 4.

³ Single Resolution Board, “Resolution of Banco Popular Español S.A.”, 7 June 2017.

⁴ European Commission, State Aid Decision SA.47677 (2017/N), 4 July 2017.

⁵ Bank Recovery and Resolution Directive (BRRD), Article 44. This 8% threshold serves as the technical lower limit for SRF mobilization.

⁶ TPIs are eligible for purchases of public sector securities with a remaining period of 1-10 years. Four criteria for eligibility for invocation are taken into consideration: 1) compliance with the EU fiscal framework, 2) the absence of serious macroeconomic imbalances, 3) sustainable finances, and 4) sound and sustainable macroeconomic policies.

⁷ There has been a historically strong correlation between austerity, which involves spending reductions, and increasing social unrest. See, for example, Ponticelli, J., & Voth, H. J. (2020). "Austerity and anarchy: Budget cuts and social unrest in Europe, 1919–2008". Journal of Comparative Economics.

⁸ When setting a scenario's threshold, past crises are referenced. For example, during the sovereign debt crisis between late 2011 and 2012, the Italian government bond (BTP) to German government bond (Bund) spread reached above 500 basis points (Source: ECB Statistical Data Warehouse, Refinitiv). In addition, in 2011, a large-scale deposit outflow of -19.9% ​​per year was observed in Greece (Bank of Greece), indicating the scale of capital flight under severe financial stress. What is expected in this scenario is that these indicators deteriorate simultaneously and in a chain.

Addendum 1: Deliverable specifications

Visualization Pack Specification

The key time series data analyzed in the report is provided as the following chart set: Each chart should clearly state the legend, unit, frequency and source. Also, at the end of each chartSource: <Institution name>, retrieved YYYY-MM-DD (freq=<D/W/M/Q>, units=<bps/%/EUR bn>)Specify the source in the following format:

1. 10-year government bond spread trend: Spread against Germany (daily) between major peripheral countries (Italy, Nishi, Nozomi)

2. Median primary line CDS: Median 5-year CDS (weekly) for representative banks in major peripheral countries (Italy, West)

3. TARGET2 Balance: Balance trends in major creditor countries (Germany) and debtor countries (Italy, West) (monthly)

4. Deposit flow: Net flow of household and corporate deposits in major peripheral countries (Italy, Nishi, Nozomi) (monthly)

5. BLS Lending Attitude DI: Corporate and mortgage lending attitudes DI (quarterly) for the entire eurozone

6. Number of social unrests: Number of social unrest events in ACLED counts in major peripheral countries (Italy, Nishi, Nozomi) (monthly)

Data Pack Specifications

Machine-readable data (CSV/JSON) for dashboard implementation conforms to the following schema:

• Common Fields: country (ISO 3166-1 alpha-2), date (ISO 8601), value, indicator_id, freq (D/W/M/Q), sa (Y/N), units (bps, %, EUR_bn, etc.), rev (revision number), source_url, retrieval_timestamp

• Monitoring frequency: Market indicators (spreads, CDS, etc.) are updated daily, while flow and statistical indicators (deposits, BLS, fiscal statistics, etc.) are updated monthly or quarterly.

Addendum 2: ACLED Event Definition

The event definitions for ACLED used in the social anxiety analysis in this report are as follows:

The main conclusions of this report are as follows: First, at the heart of the vulnerability, there remains a "home bias" by banks, the so-called "home bias." This is structurally preserved as an unintended consequence of prudence regulations, continuing to closely link the fate of banks and sovereigns. Second, the eurozone is facing a "resolution trilemma." In other words, policy authorities are unable to simultaneously achieve three goals: 1) strict enforcement of loss burdens (bail-in) to creditors under the Bank Recovery and Resolution Directive (BRRD), 2) maintaining the stability of the financial system, and 3) strict compliance with state aid regulations. Previous cases have shown that financial stability and political considerations often outweigh the strict application of rules. Third, this analysis quantitatively shows that social and political divisions are a powerful factor that amplifies financial risk. Public repulsion against fiscal reconstruction has reduced the government's ability to implement policies and is directly woven into the sovereign risk premium. This means that there is a direct feedback loop between street protests and the bond market.

In conclusion, this report presents an integrated stress scenario where global shocks -- events such as serious dysfunction in the US Treasury market -- can overwhelm existing policy response capabilities by exploiting the mutually linked vulnerabilities of the eurozone. Although the resilience of the eurozone has improved, its defensive walls are unfinished, and its true value is being questioned under a new macroeconomic environment and geopolitical risks.

Section 1: Banks in the Eurozone - Anatomy of the Sovereign Nexus

1.1. Revisiting the Doom Loop: Propagation Path and Amplification Mechanism

The harmful feedback loop between banks and sovereigns, or "doom loop," continues to be a fundamental threat to the financial stability of the eurozone. This mechanism works primarily through four interlinked propagation pathways.

1. Bank Balance Sheet RouteBanks hold a large amount of their own government bonds, especially those. If sovereigns' creditworthiness decreases and government bond prices fall, a direct valuation loss occurs on the bank's balance sheet. This damages the bank's capital and raises concerns about its solvency.

2. Collateral routeGovernment bonds are the most important collateral assets in interbank markets and in funding from central banks. Downgrading government bonds and falling prices reduce collateral value and significantly constrain banks' financing capabilities. This could directly lead to a liquidity crisis.

3. Government guaranteed route: As the banking system shakes, expectations for implicit or explicit government relief will rise. However, financially vulnerable governments lack the ability to fully function safety nets, such as deposit insurance and capital injections. Loss of confidence in government guarantees increases the risk of deposits flowing, or bankrans.

4. Macroeconomic Path: The sovereign fiscal crisis forces austerity (tax increases and spending cuts). This significantly suppresses domestic economic activity and increases corporate bankruptcies and household defaults. As a result, the bank's financial situation will deteriorate further as the quality of its assets loaned and the number of bad debts increases.

These pathways interact and amplify negative feedback. The vicious cycle in which the sovereign crisis weakens banks, and the weakened banking system further undermines confidence in the sovereign is the essence of the Doom Loop. This dynamic is structurally similar to that envisaged in the Walpurgis systemic crisis scenario, which starts with dysfunction in the US Treasury market. In this scenario, the story depicts a self-amplifying spiral in which the initial shock of a government bond bid is paralyzed by the primary dealer (major banks) through balance sheet constraints, which forces further sales of assets through the central clearing agency (CCP) request for margin. Similar amplification mechanisms are potentially present in the eurozone.

1.2. Empirical mapping of core vulnerabilities: Bank sovereign exposure

Empirically confirming the existence of the doom loop is the data provided by the European Banking Authority (EBA) risk dashboard. This data highlights the current state of so-called "home bias" how eurozone banks are deeply exposed (risk) to their country's sovereign debt.

Table 1 below summarizes the exposures of domestic sovereign debts held by selected eurozone banking sectors as of the first quarter of 2025. In particular, the ratio to equity (CET1) indicates the magnitude of the potential impact that fluctuations in sovereign debt prices have on bank solvency.

Table 1: Banking sector's home sovereign exposure in selected eurozone countries (Q1 2025)

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Source: European Banking Supervisory Authority (EBA) "Risk Dashboard Q1 2025 Statistical Annex"¹

This data shows some important facts. First, banks in countries that have experienced sovereign stress in the past, such as Italy, Spain and Greece, still hold a large amount of their own government bonds, which amount to around twice their capital. This means that if the government bond yields of these countries rise by 100 basis points, if the other conditions are constant, the bank's capital could be damaged by more than 10% on the books by simple calculation (assuming the duration is approximately five years). Secondly, banks from "core" countries such as Germany and France also own a considerable amount of their own government bonds, but their size is relatively small when viewed in terms of total assets and capital. Third, Ireland has managed to significantly reduce banks' dependence on their sovereigns after the crisis.

This home bias is deeply rooted by the structure of regulations, not just a market coincidence. The prudential regulation framework set forth by the Basel Committee on Banking Supervision (BCBS) has long been permitted to apply a 0% risk weight to its own sovereign exposure in its own currency in standard practice. This means that when banks hold their own government bonds, they do not need to accumulate capital. This regulatory incentive has provided a strong incentive for banks to hold their own government bonds, and has, as a result, laid the structural foundation for the Doom Loop. Although the introduction of positive risk weights and centralized levy levies to sovereign exposure has been discussed within the BCBS and the European Systemic Risk Board (ESRB), political resistance concerning the liquidity of the government's bond market and impact on fiscal finance has not been achieved, leading to drastic reforms.

1.3. Mitigation factors: Assessment of asset quality and equity fulfilment

Meanwhile, since the 2012 crisis, resilience in the eurozone banking sector has improved significantly. Data from the EBA risk dashboard shows an improvement in capital adequacy ratio and a significant decline in the Non-Performing Loan (NPL) ratio.

• Capital fulfilmentAs of the first quarter of 2025, the average common stock tier 1 (CET1) ratio for EU/EEA banks remains at 16.2%, a high level that is significantly higher than regulatory requirements. This means that the buffer to absorb certain shocks, including valuation losses on sovereign debt, is thicker than in the crisis.

• Quality of assetsBanks in particular in Italy, Spain and Greece have been largely disposing of bad debts over the past decade, and the NPL ratio has fallen to historic lows. This increases the bank's balance sheets' resistance to macroeconomic deterioration.

However, it is premature to believe that even with these improvements, the risk of the Doom loop has been completely eliminated. As shown in Table 1, in some countries' banking systems, the size of their national sovereign debt exposure still outweighs their capital. Therefore, in the event of a serious sovereign shock, even an improved capital buffer remains at the risk of erosion in a short period of time. The problem lies not in peacetime resilience, but in vulnerability to extreme tail events.

Section 2: Fragmentation as a Systemic Threat: Market and Economic Aspects

Financial fragmentation refers to a situation in the eurozone, a single currency area, where the funding costs and access to credit faced by businesses and households differ significantly depending on the country of residence, which hinders the smooth transmission of a single monetary policy. This is a division of financial markets and a systemic threat that widens economic disparities.

2.1. Real-time indicators of fragmentation: Sovereign spreads and TARGET2 imbalance

The most important real-time market indicators for measuring the progress of financial fragmentation are the imbalance between national government bond yield spreads and TARGET2, a payment system within the euro system.

• Sovereign spread: Using the yields on German government bonds (Bund) as the benchmark, the difference (spread) between the 10-year government bond yields in other eurozone countries directly reflects how the market rates the sovereign risks of each country. During the crisis between 2011 and 2012, Italy and Spain's spread with Germany expanded to above 500 basis points, fueling concerns about eurozone division. Spreads have shrunk significantly since the European Central Bank (ECB)'s powerful intervention, particularly since President Mario Draghi's "Whatever it takes" statement and the announcement of the last Outright Monetary Transactions (OMT) as a buyer), but they still fluctuate to reflect market tensions. The trend of spreads growing again in response to recent trends in interest rate normalization and increasing political uncertainty suggests that fragmentation risk is constantly latent.

• TARGET2 Imbalance:TARGET2 is a system that processes cross-border fund settlement within the eurozone. The net amount of debt and obligations held by national central banks (NCBs) in each country to the ECB is the TARGET2 balance, and the imbalance reflects capital flows within the eurozone. During the crisis of 2011-2012, massive private capital flight occurred from southern European countries to Germany. This outflow of private capital was filled by central bank money borrowed from the NCBs of Southern European countries, resulting in a massive debt (TARGET2 surplus) of the German Federal Bank to the ECB and a massive debt (TARGET2 deficit) of the Italian and Spanish banks to the ECBs. Therefore, the expansion of the TARGET2 imbalance at the time was a clear signal indicating capital flight and the aggravation of financial fragmentation.

Care must be taken when interpreting these indicators. After the launch of the Quantitative Easing (QE) programme by the ECB since 2015, the TARGET2 imbalance has grown again, but the main factor was not capital flight, but technical, asset purchase settlements were primarily made through German financial institutions. Therefore, in situations where technical factors like QE are not in the background, the rapid expansion of the TARGET2 imbalance coinciding with the expansion of sovereign spreads should be interpreted as an extremely dangerous signal indicating a rekindling of serious capital flight in the 2012 model.

2.2. Transmission to the real economy: credit contraction and deposit outflow

Financial fragmentation is more than just a problem with financial markets. It has a serious impact on the real economy through its credit channel.

• Credit status: As sovereign risk increases, banks in the country face damage to their balance sheets and rising funding costs, hardening their lending attitudes. The ECB's quarterly Bank Lending Survey (BLS) clearly illustrates this mechanism. During the crisis in 2012, Italian and Spanish banks significantly tightened lending standards for businesses and households compared to German banks, which contributed to the serious economic downturn in both countries. The expansion of sovereign spreads will directly lead to rising borrowing rates for domestic businesses and households and a tight credit stump, blocking the effects of the ECB's accommodative monetary policy.

• Deposit flow: As fragmentation becomes more severe and concerns about the health of their banking system grow, depositors will move funds to banks in countries that are considered safer. This causes deposit outflows, also known as "quiet banks." Financial institution balance sheet statistics published by national central banks are an important data source for tracking the inflow and outflow of deposits from households and non-financial corporations during times of crisis. In 2012, significant deposit outflows were observed in Greece and Spain, further straining bank liquidity and exacerbating the Doom loop. This trend in deposit flows is an indicator that should be monitored very closely as a barometer of confidence in the financial system.

Section 3: Eurozone Institutional Gauntlets: Defenses and Defects

In response to the sovereign debt crisis, the eurozone has created a complex institutional framework to address systemic risk. However, this framework encompasses fundamental tensions surrounding fiscal discipline, bank resolution and the role of central banks, and is inherently vulnerable.

3.1. Financial backstop: Stable and Growth Agreement (SGP) and its political limits

The foundation of the eurozone's fiscal discipline is the stability and growth pact (SGP). The SGP requires member countries to keep their fiscal deficits within 3% of GDP and their government debt balances within 60% of GDP. The rules aim to prevent excessive fiscal deficits from causing negative ripple effects on the entire monetary union.

However, the operation of the SGP has always faced political challenges. The application of strict rules will deprive countries of discretion, particularly during recession, making it difficult to implement anti-cyclical fiscal policies. Therefore, in response to serious economic shocks such as the COVID-19 pandemic, the "general escape clause" was invoked and SGP rules were temporarily suspended. The existence and invocation of this clause indicates that SGP is a framework that is flexibly operated by political judgment, rather than rigid rules.

SGP rules have been reapplied since 2024, but many member states have far surpassed the 60% standard in debt levels as a result of their response to the pandemic and energy crisis. Eurostat data shows that debt ratios in Italy, Greece, France and Spain remain below 100%, and these countries will be subject to continued fiscal reconstruction pressure under the SGP in the future. This demand for fiscal reconstruction is a spark to social and political tensions, which will be discussed later, and in itself creates a paradox of increasing sovereign risk.

3.2. Loop cutting: the reality of Bank Rehabilitation Resolution Directive (BRRD) and the state subsidy

A central institutional reform to break the doom loop is the introduction of the Bank Recovery and Resolution Directive (BRRD). The heart of BRRD is that it has established the "bail-in" principle in which bank shareholders and creditors are responsible for the losses, instead of taxpayer bailouts. This aimed at internalizing the costs of bank bankruptcy and cutting off the burden on government finances.

However, the strict application of BRRD creates complex tensions with the EU's state aid regulations. State Aid rules generally prohibit government support for certain companies from distorting market competition. Injecting public funds into banks is highly likely to violate this rule.

The real-world operation of this institutional framework is illustrated by two contrasting cases.

{Case A: Banco Popular (2017)—Pure treatment}

This case is considered a "pure" resolution in which BRRD functions as intended. After being recognized by the European Central Bank (ECB) as "failing or likely to fail," the bank was then sold to Santander Bank for 1 euro, under the decision of the Single Resolution Board (SRB) when shareholders and subordinated creditors were completely bailed out of the losses. During this process, no public funds or funds from the Single Resolution Fund (SRF) were put into use, and no issues with State Aid regulations were raised.

Case B: MPS (2017)—Exception recognition and national aid

This is a more complicated case. The bank was found to have a capital shortage after a stress test, but was judged to be "solvent (they are able to pay)." This led the Italian government to inject public funds using the BRRD exception provisions called "precautionary recapitalisation." The measure circumstanced a stake in the losses (Baden sharing) to subordinated creditors while avoiding complete resolution. The European Commission has approved this under State Aid Rules as a measure to avoid serious economic disruption.

These cases highlight the "resolution trilemma" that the eurozone faces. Policy authorities can only achieve two goals simultaneously: 1) strict bail-in under the BRRD, 2) maintain stability in the financial system, and 3) adhere to State Aid regulations. The European resolution framework, not the usual domestic bankruptcy proceedings, is only applicable if the Single Resolution Committee (SRB) determines that the resolution is "in the public interest" for the purposes of maintaining financial stability (Public Interest Assessment (PIA). Furthermore, the use of a Single Resolution Fund (SRF) is subject to a preliminary loss burden (bail-in) by shareholders and creditors, which in principle corresponds to 8% or more of the bank's total liability. In the case of Banco Popular, ① and ③ were given priority, while in the case of Monte dei Paschi, ① was only partially applied to prioritize ②, and ③ was overcome by exception provisions. These cases suggest that in the event of a large systemic crisis, maintaining financial stability (2) is likely to be the top priority, with flexible interpretation of rules and exceptional public support likely.

3.3. ECB as the last bastion: From OMT to the transmission protection mechanism (TPI)

The last bastion of eurozone's institutional defense is the ECB's crisis response tool. The ECB's actions are strictly constrained by Article 123 of the TFEU (Treaty on the Functioning of the European Union), which prohibits direct fiscal financing to member state governments, and Article 125, which is a "no-bailout clause" that prohibits relief between member states. The ECB's crisis response tools are designed with the aim of protecting monetary policy transmission mechanisms while complying with these legal constraints.

• Flexible reinvestment in PEPP: The plan is to concentrate reinvestment of bond redemption funds purchased through the Pandemic Emergency Purchase Programme (PEPP) in government bonds in a particular country when the government bond market is exposed to tension. This is positioned as the primary line of defense to combat fragmentation. PEPP has the flexibility to allow divergence from the capital keys of each country than the traditional Public Sector Purchase Programme (PSPP).

• Transmission Protection Instrument (TPI): A more powerful backstop introduced in July 2022. TPI allows government bonds from certain countries to be purchased in the secondary market to counter the "unfair and disorderly market dynamics that seriously threaten the transmission of monetary policy." Purchases under TPI will focus on public sector securities with a remaining period of one to ten years. The invocation of the TPI is at the discretion of the ECB Board, but the following criteria will be cumulatively considered in determining their eligibility:

  • 1. Compliance with the EU fiscal framework: Not subject to the excess fiscal deficit procedure (EDP).

  • 1. The absence of serious macroeconomic imbalances: Not subject to the Overimbalance Procedure (EIP) and not rated as failing to take corrective action.

  • 1. Financial sustainability: Public debt is determined to be sustainable based on analysis by the European Commission, the European Stability Mechanism (ESM), the International Monetary Fund (IMF), etc.

  • 1. Healthy and sustainable macroeconomic policy: Complying with commitments set forth in the Reconstruction and Resilience Facility (RRF) and country-specific recommendations in the European semester.

These standards are intentionally left ambiguous and give the ECB great discretion. However, at the same time, this means that the activation of the TPI will be a highly political decision rather than a purely technical decision. Determining whether a country's financial situation or policy meets the criteria is heavily influenced by the political dynamics between the European Commission and member states. This puts the ECB in an extremely difficult position, effectively reviewing member states' policy compliance, while still acting as the last bastion of financial stability, without democratic legitimacy.

Section 4: Social fault lines: fiscal reconstruction and political risks

Financial markets and institutional frameworks do not exist within a vacuum. They are deeply defined by social stability and political dynamics. In the eurozone, the demand for fiscal reconstruction often leads to social backlash, which creates political instability and ultimately forms a negative loop of increasing the sovereign risk itself.

4.1. The price of stability: austerity, social unrest, and sovereign risk premium

Requiring fiscal reconstruction under SGPs often involves austerity, which inflicts pain on the public, such as spending cuts and tax increases. This directly leads to an increase in social unrest. Event datasets such as the Armed Conflict Location & Event Data Project (ACLED) and the GDELT project allow for quantitative tracking of the frequency and intensity of social anxiety events such as strikes, demonstrations and riots.

Analyzing data from Greece, Spain and Italy from 2010 to 2015 shows a strong positive correlation between a period when government interest payments (to GDP) rose sharply and financial pressure was at its peak, and when social unrest events occurred. This empirical evidence suggests that financial market stress directly undermines social stability through the pathway of austerity⁶.

This relationship is not one-way. Social unrest is itself a factor that increases sovereign risk. Financial markets assess not only the level of debt of a government, but also the ability and willingness of the government to politically and socially implement fiscal reconstruction measures necessary to repay the debt. Large, sustained social unrest causes serious doubts about governments' ability to implement policies, prompting investors to demand a higher risk premium. In other words, the intensification of street protests directly bounces back to government funding costs, in the form of rising government bond yields. In this way, a self-amplifying feedback loop is formed between the social class, institutional class (fiscal discipline), and market class (sovereign spread).

4.2. The impact of political fragmentation on market trust and institutional cohesion

Social unrest encourages political fragmentation. Frustration with austerity has diminished support for existing mainstream parties and prompted the rise of populist and euroskeptic parties. This political division exacerbates the doom loop in a double sense.

First, its impact on the market. Market uncertainty increases as political instability increases and future policy foreseeability decreases. In particular, when the likelihood of an administration coming into question the eurozone framework and commitment to fiscal discipline increases, investors will be demanding additional risk premiums from the country's sovereign bonds, which incorporate the risk of redenomination of the currency.

Second, its impact on the system. The eurozone's crisis response capabilities rely on political cohesion and cooperation among member states. Important institutional reforms, such as the completion of banking alliances (particularly the establishment of the European Deposit Insurance Scheme (EDIS)) and SGP reforms, require consensus building between member states. However, as domestic political divisions deepen in each country, the movement to prioritize national interests will be strengthened, making it difficult to compromise and cooperate for the interests of the entire eurozone. This will slow the strengthening of the eurozone institutional defense barriers and increase system-wide vulnerability.

Section 5: Integrated Stress Scenario Analysis and Strategic Implications

The final section of this report combines previous analyses and presents a forward-oriented stress scenario to assess the systemic risks facing the eurozone. This scenario is not a prediction, but rather shows the logical consequences of possible situations when identified vulnerabilities are chained together.

5.1. Eurozone version of "Walpurgis"? : A chain of bankruptcy points in a new crisis

The starting point for the analysis is to envisage the occurrence of serious risk-off events in global financial markets. This could be an exogenous shock, such as a serious dysfunction in the US Treasury market, as depicted in the analytical material "Walpurgis" scenario provided. Below we will detail how this shock spreads through the three interlinked layers of the eurozone (markets, institutions, and society) and tests existing defensive barriers.

1. Initial shocks in the market: A global "escape to quality" begins, investors sell risky assets and move funds to the safest assets. This will cause the yields on German government bonds to fall sharply, while sovereign spreads in neighboring countries such as Italy and Spain, which are considered financially vulnerable. This spread expansion hits the balance sheets of banks in these countries and immediately creates a huge valuation loss through the large domestic sovereign exposures analyzed in Section 1.

2. Dysfunction in the institutional class: The ECB's first line of defense, TPI, will be tested. However, if the country that epicenter of the shock does not fully meet SGP standards and is also behind in structural reforms, political conflicts will arise within the ECB board over the invocation of the TPI. Some "hawks" countries are concerned about moral hazard and oppose intervention without strict conditionality. Panic is accelerated as market observations that TPI will be delayed or limited. At the same time, one of the major domestic banks will suffer a serious capital shortage, resulting in the need for resolution. The "trilemma of resolution" discussed in Section 3 here becomes a reality. To prevent systemic transmission, senior creditors and large depositors need to be protected, but this is contrary to the principles of the BRRD and is difficult to obtain approval from other member states under State Aid Rules. They have fallen into an institutional dead end and are unable to respond promptly and decisively.

3. Amplification in the social classFaced with market pressure and demands from the EU, the government is forced to launch a radical austerity package to restore market confidence. This immediately causes social unrest such as large-scale protests and strikes, as analyzed in Section 4. Social turmoil develops into a political crisis, coalition government collapses, and parliament is forced to dissolve.

4. Final Feedback Loop: The occurrence of a political blank will decisively ensure that "sound and sustainable macroeconomic policies" which are prerequisites for the activation of TPIs will not be met. The ECB loses its basis for intervention, and the market realizes that the last bastion will not work. Sovereign spreads have skyrocketed to uncontrollable levels, and government bond markets are effectively shut down. This will cause the entire domestic banking system to fall into a solvency crisis, and deposit outflows will accelerate. Here, a Doom loop, which is larger than the 2012 crisis, is completed, and the Eurozone enters an out-of-control systemic crisis.

5.2. Strategic Implications for Surviving Rekind Fragmentation

This stress scenario shows that the eurozone defense barrier remains incomplete and can break down if multiple vulnerabilities are manifested simultaneously. From this analysis, the following higher order strategic implications are derived:

• Implications for policy authorities：

  • Completion of the Banking Alliance: In breaking the chain of risk, the completion of a banking alliance, including the establishment of a European Deposit Insurance Scheme (EDIS), remains the most important issue.

  • Reform of fiscal rules: There is a need to reform SGP into a more realistic, politically viable framework that promotes sustainable growth and enables counter-cyclical fiscal policies, not just strict numerical targets.

  • Clarifying the role of the ECB: It is essential to form clearer political consensus in advance that reduces political ambiguity around the criteria for invoking the TPI and allows the ECB to act quickly within its mandate.

• Implications for institutional investors：

  • Building an integrated risk model: It is urgently necessary to create an integrated sovereign risk assessment model that incorporates political risk and social unrest indicators as quantitative inputs into traditional economic and financial models. Data sources like ACLEDs should no longer be supplementary information and should be at the core of risk assessment.

  • Stress test for institutional bankruptcy points: Portfolio stress testing should not only take into account the rise in market volatility, but also institutional collapse scenarios such as "TPI not invoked" and "BRRD not applied for political reasons."

  • Breaking the trap of regulation:Recognizing that regulatory preferential treatments such as 0% risk weights do not reflect true risk, we should proceed with strategic diversification from overly concentrated sovereign exposures, within the limits that the regulations allow.

In conclusion, the eurozone has learned much from past crises and has strengthened its system. However, the fundamental dynamics of the Doom Loop still exist, and the threat is reshaping and rekindling due to new macrofinancial environments and social and political rifts. The next crisis is likely to manifest not as a pure economic or financial crisis, but as a hybrid crisis that involves a complex intertwining of markets, institutions and societies. That preparation is not yet sufficient.

footnote

¹ Public data from the European Banking Supervisory Authority (EBA) (https://www.eba.europa.eu/risk-and-data-analysis/risk-analysis/risk-monitoring/risk-dashboard) was created based on data obtained on September 14th, 2025. The numbers are calculated from the related table. The formula for "Our country exposure / CET1 capital (%)" is (Our country sovereign exposure) ÷ (CET1 capital) x 100. The duration statement in this text is an example based on a general assumption of price sensitivity (duration 5 years) and is not used directly to calculate this table.

² The ECB analysis points out that the expansion of the TARGET2 imbalance after the initiation of quantitative easing (QE) is primarily technically attributed to the settlement structure of asset purchases, and is essentially different from capital flight during a crisis. ECB Financial Stability Review, May 2017, Box 4.

³ Single Resolution Board, “Resolution of Banco Popular Español S.A.”, 7 June 2017.

⁴ European Commission, State Aid Decision SA.47677 (2017/N), 4 July 2017.

⁵ Bank Recovery and Resolution Directive (BRRD), Article 44. This 8% threshold serves as the technical lower limit for SRF mobilization.

⁶ A strong historical correlation has been pointed out between austerity, which involves spending reductions, and increasing social unrest. See, for example, Ponticelli, J., & Voth, H. J. (2020). "Austerity and anarchy: Budget cuts and social unrest in Europe, 1919–2008". Journal of Comparative Economics.

⁷ When setting a scenario's threshold, past crises are referenced. For example, during the sovereign debt crisis between late 2011 and 2012, the Italian government bond (BTP) spread to Germany (Bund) reached above 500 basis points. In addition, in 2011, a large-scale deposit outflow of -19.9% ​​per year was observed in Greece, indicating the scale of capital flight under severe financial stress. What is expected in this scenario is that these indicators deteriorate simultaneously and in a chain.

Addendum 1: Deliverable specifications

Visualization Pack Specification

The key time series data analyzed in the report is provided as the following chart set: Each chart should clearly state the legend, unit, frequency and source.

1. 10-year government bond spread trend: Spread against Germany (daily) between major peripheral countries (Italy, Nishi, Nozomi)

2. Median primary line CDS: Median 5-year CDS (weekly) for representative banks in major peripheral countries (Italy, West)

3. TARGET2 Balance: Balance trends in major creditor countries (Germany) and debtor countries (Italy, West) (monthly)

4. Deposit flow: Net flow of household and corporate deposits in major peripheral countries (Italy, Nishi, Nozomi) (monthly)

5. BLS Lending Attitude DI: Corporate and mortgage lending attitudes DI (quarterly) for the entire eurozone

6. Number of social unrests: Number of social unrest events in ACLED counts in major peripheral countries (Italy, Nishi, Nozomi) (monthly)

Data Pack Specifications

Machine-readable data (CSV/JSON) for dashboard implementation conforms to the following schema:

• Common Fields: country (ISO 3166-1 alpha-2), date (ISO 8601), value, indicator_id, freq (D/W/M/Q), sa (Y/N), units (bps, %, EUR_bn, etc.), rev (revision number), source_url, retrieval_timestamp

• Monitoring frequency: Market indicators (spreads, CDS, etc.) are updated daily, while flow and statistical indicators (deposits, BLS, fiscal statistics, etc.) are updated monthly or quarterly.

Addendum 2: ACLED Event Definition

The event definitions for ACLED used in the social anxiety analysis in this report are as follows: