Sovereign defaults in Emerging Markets and Developing Economies (EMDEs) increased significantly after the Covid-19 pandemic, with 31 defaults in 2020 and 38 in 2021. According to the World Bank Group’s latest International Debt Report, external debt burdens across low- and middle-income countries continue to build, reaching a record US$8.9 trillion in 2024, with interest payments climbing to an all-time high of US$415 billion—straining fiscal space just as more countries confront rising risks of default.
Sovereign defaults in recent years in countries like Sri Lanka, Ghana, and Lebanon impacted financial systems and signaled future challenges for other EMDEs with similar fiscal and external vulnerabilities. Sri Lanka’s default on its foreign sovereign debt in 2022, for instance, was the first in its history. The run-up to the sovereign default was marked by a tide of economic adversity and a financial sector heavily exposed to the sovereign through rising holdings of government securities. The country introduced import restrictions amidst an economic downturn, as international reserves dwindled when they were used to service international debt and to preserve the exchange rate level. The collapse of the exchange rate and the sovereign default that followed set the stage for a contraction in economic activity and put the spotlight on banks’ overexposure to the distressed sovereign.
Other countries followed a similar script:
- rising sovereign stress due to persistent fiscal deficits and unsustainable public debt levels,
- weak external positions manifested through current account deficits and low international reserve coverage. These fiscal and external pressures increasingly shifted government financing needs to the domestic domain—primarily banks and financial institutions, and
- exposing the financial sector to heightened sovereign risk.
As international investors grew wary of these fiscal weaknesses post-pandemic, governments’ access to external market financing diminished and reliance on the domestic financial sector increased. The sovereign-financial sector nexus deepened, leaving the financial sector’s soundness vulnerable to a government whose creditworthiness was under acute pressure.
Resolving combined sovereign-bank crises, commonly known as conglomerate crises, is highly complex given interactions between macro and financial sector variables, lack of monetary and fiscal policy space, and the need for painful reforms across a broad range of policy areas, often under acute time pressure. Bail outs funded by taxpayer money are often not an option given the lack of government fiscal buffers.
Countries need modern bank resolution regimes to reduce fiscal costs during bank failures. Such tools help set failing financial institutions aside from the general corporate insolvency framework, enabling early and prompt intervention that preserves depositors’ funds. A resolution framework also provides robust statutory powers to carve out assets and liabilities (e.g. purchase and assumption transactions) and writing down or converting liabilities into equity (i.e. bail-ins), among others. This is in contrast with bailouts, where governments would use public funds to recapitalize failed institutions.
The scarcity of financial instruments in EMDEs that can be bailed in leaves policymakers with fewer options and puts uninsured depositors at risk, which is unpopular and disruptive. The ultimate objective is to shield public funds from bailing out failed financial institutions, imposing losses on private sector creditors, in a manner that protects lower-income households and small firms. This requires a well-funded deposit insurance scheme that can quickly protect small depositors and support the orderly resolution of failing banks. While such schemes are becoming more common in EMDEs, they are still far from universal.
Liquidity pressures typically intensify during sovereign debt distress, so a fully operational Emergency Liquidity Assistance (ELA) framework is essential to prevent sudden, contagious bank runs. Standard ELA policies, such as collateralized lending at penalty rates and only to banks that are solvent but temporarily illiquid, continue to hold, but conglomerate crises present unique challenges. For example, demand for scarce FX liquidity may surge and may be impossible to meet in an environment of capital flight and depleted foreign exchange reserves.
Conglomerate crises challenge multiple government agencies due to their interconnected nature. A holistic approach and strong coordination between fiscal, monetary, and financial sector policies is crucial. This requires clear interagency coordination arrangements that define decision-making roles in line with each authority’s legal mandate, ensuring a timely and coordinated policy response. These agencies are primarily the central bank, ministry of finance, deposit insurance and financial supervisory agencies.
The World Bank Group has partnered with countries around the world, including Ghana, Lebanon, and Sri Lanka, to confront challenges during conglomerate crises, and help them prepare robust financial safety nets that can effectively address the risks associated with conglomerate crises. This includes facilitating the development of comprehensive frameworks for prudential supervision, emergency liquidity assistance, and modern bank resolution and deposit insurance regimes.
By offering technical expertise, resources, and strategic guidance, the World Bank Group empowers EMDEs to implement proactive reforms that enhance financial sector stability and resilience, while developing domestic financial markets. The World Bank Group's commitment to fostering financial stability underscores its dedication to supporting countries in building sustainable and inclusive economies.
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