Financial sector vulnerabilities in emerging market and developing economies (EMDEs) are largely divided along income lines. While vulnerabilities are low to moderate in higher-income EMDEs, half of lower-income countries face much higher risks. In addition, progress on financial development goals such as local capital market deepening has stalled in many countries. Advances, however, have been made on financial inclusion for individuals and in efforts to green the financial sector.
Meanwhile, EMDE banks substantially increased their holdings of government debt. These exposures currently stand at a decade high and subject the financial sector to additional risks, particularly in countries with weaker macroeconomic policies and public debt sustainability challenges.
In addition, climate change is particularly challenging for EMDEs because they face higher risks from it than advanced economies as well as larger climate financing gaps. Despite being the largest source of finance, the banking sector in EMDEs supplies only limited climate finance. EMDE banking authorities are beginning to adopt tools and innovate in their approaches to address climate-related financial sector vulnerabilities and climate finance gaps, though they will need to avoid compromising on important objectives of financial stability and inclusion.
Chart #1: Financial sector vulnerabilities are divided along income lines
The financial sector risk outlook for EMDEs is largely divided along income lines. Over the next 12 months, vulnerabilities appear low to moderate in higher-income EMDEs, while several lower-income countries are significantly more vulnerable. In many of these countries, domestic vulnerabilities are exacerbated by global risks related to the monetary policy and growth outlook in advanced economies, as well as by geopolitical conflicts.
The country risk assessment is based on World Bank expert judgment, informed by the state of the financial sector policy framework and macro-economic and financial data.
Chart #2: EMDEs with high financial vulnerabilities often lack the capacity to deal with financial sector stress
A majority of the countries facing high financial sector risks are currently not well prepared to handle financial sector stress. They face important weaknesses in regulatory and supervisory frameworks and essential components of crisis management frameworks and financial sector safety nets are often missing or inadequate. These vulnerable countries should take urgent steps to remedy critical policy and institutional gaps in order to improve the resilience of their financial sectors.
Chart #3: Banks in debt-distressed countries have higher exposure to government debt
EMDE banks substantially increased their holdings of government debt in recent years, a situation known as the sovereign-bank nexus. The exposure of banks to government debt in EMDEs rose by more than 35 percent from 2012 to 2023 as governments borrowed more, partly to deal with the COVID-19 pandemic. The exposure rose even more—by over 50 percent—in debt-distressed countries.
Chart #4: The risk of joint government debt-banking crises is elevated in some countries
Excessive government debt exposures among EMDE banks mean government debt distress could be contagious and trigger banking crises. Such combined crises have been particularly damaging in the past, leaving GDP per capita significantly lower than it otherwise would be. New analysis finds that countries with a high sovereign-bank nexus tend to be less prepared to deal with financial stress. While broader policies that preserve public debt sustainability and macroeconomic stability are necessary, EMDE banking authorities should shore up their financial crisis management and safety net frameworks and consider introducing disclosure requirements for banks’ exposures to the government to encourage more prudent risk taking by banks and foster market discipline.
Chart #5: EMDE banks dominate the financial sector—but they currently provide very little climate finance
In addition to elevated climate risks, EMDEs face a substantial shortage of financing for low-carbon and climate-resilient growth—with more limited domestic and private sector financing for climate goals. Most climate finance is channeled toward China and advanced economies, predominantly for mitigation purposes. Adaptation accounts for only 16 percent of domestic and international climate finance in developing economies (excluding China) is channeled for adaptation. Out of this small share, 98 percent is either public resources or official financing.
Source: World Bank staff calculation based on Buchner et al. (2023) and World Bank (2023d) Note: Panel a: Because of rounding, the numbers presented may not fully match across the different flows. “Multiple objectives” covers financing for projects that provide both mitigation and adaptation benefits. “Unknown” implies uses that cannot fully be traced. “Regional” refers to climate flows that are not confined to a single region but instead span across multiple regions. bn = billion; EAP = East Asia and Pacific; ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; MENA = Middle East and North Africa; SAR = South Asia region; SSA = Sub-Saharan Africa.
Banks dominate the financial sector landscape in these countries. With more than 80 percent of financial sector assets, they have the potential to play an important role to finance climate adaptation and mitigation. Yet according to a World Bank survey, climate financing is 5 percent or less of the lending portfolio for nearly 60 percent of EMDE banks – with 28 percent providing no climate financing at all.
Chart #6: EMDE banking authorities have begun to tackle climate change—but much work remains
Central banks and prudential authorities are starting to implement approaches to address climate-related financial sector risks and mobilize climate finance – though guidance for applying them is lacking and their potential effectiveness is both mixed and unproven in some cases. Banking authorities must therefore take care to prioritize financial stability and continue to promote financial inclusion and efficiency. Based on experience to date, tools can broadly be divided into three categories: win-win, jury’s still out, and not recommended. The sheer size of the climate financing gap will require support from beyond the banking sector—from central governments (through fiscal policies like carbon pricing) as well as deeper capital markets and national development financial institutions.
This blog is based on themes discussed in the recently launched Finance and Prosperity Report 2024.
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