Spain’s  banks are booking billions of euros in trading profits linked to their large  holdings of Spanish sovereign bonds, in a boost to earnings that highlights how  closely the fate of the country’s lenders is tied to the financial health of the  government in Madrid.

The sharp jump in trading profits is a direct result of  the eurozone carry  trade, in which banks from countries such as Spain and Italy borrow money  cheaply from the European Central Bank to buy high-yielding sovereign debt from  their own governments.

The increasingly tight linkage between eurozone banks and  their sovereign, also known as the “doom  loop”, has long been a source of concern for regulators and investors. Their  fear is that lenders in a financially stricken country will suffer a crippling  hit to their balance sheets just when their government is least able to finance  a bailout of the banking system.

Spanish banks have been among the most enthusiastic users of the ECB’s  emergency liquidity scheme, tripling their holding of Spanish sovereign bonds  since the start of the crisis. According to the latest data from the ECB, the  country’s lenders were sitting on €272bn of Spanish sovereign bonds last month,  up from just €94bn at the end of 2007.

Contrary to market fears at the height of Spain’s banking crisis in 2012,  these bonds have soared in value over the course of last year, prompting banks  to sell down part of their portfolio and allowing them to reap a windfall  trading profit that is set to become one of the defining features of this year’s  reporting season. Over the past two months alone, Spanish banks have sold more  than €33bn of government bonds, according to ECB data.

Some of the country’s midsized banks have already reported sharp rises in  trading profits, bolstering earnings at a time when their home market is still  struggling to shake off the legacy of the recent crisis.

Analysts expect Spain’s biggest banks to benefit from  their holdings of sovereign bonds as well, though the impact will be less  dramatic because of their size and international diversification. Santander, BBVA and Caixabank, all of which report full-year results  this week, together held Spanish sovereign bonds worth €91bn at the end of the  third quarter last year.

Banco Sabadell, which released its full-year  results last week, said trading profits for the year 2013 rose 170 per cent to €1.48bn – almost 40 per cent of its total annual revenue. Sabadell’s trading  profits in 2013 were almost seven times higher as a proportion of total revenues  than the average in the years between 2000 and 2011, according to calculations  by Exane BNP Paribas.

“Trading gains [at Sabadell] have moved from 5 per cent of revenue in 2008 to  20 per cent of revenue in 2012 to 40 per cent of revenues in 2013,” said  Santiago López, bank analyst at Exane BNP Paribas. He points out that such gains  will be hard to repeat, not least because the spread between the ECB’s cheap  loans and Spanish government debt has narrowed markedly over the past year.

Bankinter, the only other Spanish lender that has  released earnings so far, revealed a 58 per cent jump in trading profits to €229m.

Banco Popular, which is due to release its  full-year results on Friday, is also expected to report a notable rise in  trading profits, as will Bankia, the former savings bank that was nationalised  by Madrid at the height of the banking crisis in 2012. Nomura, the  investment bank, predicts that trading gains at Bankia, for example, will rise  almost 60 per cent to about €680m.

“There were times when investors were very worried about banks’ sovereign  bond exposure. The market was freaking out,” said Daragh Quinn, a Madrid-based  bank analyst at Nomura.

While concerns over a possible break-up of the eurozone or a Spanish default  have receded sharply, he argued that the banks’ current heavy reliance on  trading profits and income from this portfolio still raises questions. “This  kind of performance is unsustainable, so the question is what happens next.  Where will the improvement come from?” asked Mr  Quinn.