The sovereign-bank nexus in EMDEs: What is it, is it rising, and what are the policy implications?

The global financial crisis has shown once more the potency of the sovereign – bank nexus. The nexus reflects the interconnectedness between the health of the sovereign and the banking system, whereby stress in one sector may create and amplify stress in the other. In a new working paper, we provide a conceptual framework (Figure 1) and identify two direct channels (bank’s direct exposures to the sovereign and - the presumption of - government support to failing banks) and two indirect channels (fiscal and bank interactions with the real sector).

Figure 1 - The sovereign - bank nexus: two direct and two indirect channels

In the decade since the global financial crisis, we find that conditions across emerging markets and developing economies (EMDEs) have emerged that may strengthen and activate the sovereign-bank nexus. However, deeper country-level analysis is required given country idiosyncrasies, including the structure of sovereign debt and the composition of the investor base and data lags and opacities. With these important caveats, our analysis of 140 Emerging and Developing Economies (EMDEs) presents the following main findings:

• First, banks have increased their exposures to their sovereign, both relative to their balance sheets and country GDP -- this tightens the exposure channel. For example, the median banking system has seen its total exposures to government and non-financial public entities increase more than double since 2007, reaching a median of 8% of GDP (Figure 2). Supported by a quantitative analysis for 36 EMDEs, we find that this increasing exposure to the sovereign is positively associated with the probability of default of financial institutions.
• Second, government debt has grown and fiscal positions have deteriorated raising the specter of sovereign stress, particularly in an environment in which global financial conditions may suddenly tighten after potential adverse shocks or changes in global investors’ risk appetite -- this tightens all direct and indirect channels and may activate the nexus.
• Third, banking systems assets and bank credit to the private sector have increased which may restrict the sovereign’s capacity to contain a costly banking crisis – this tightens the government support channel. Although bank buffers have improved in the post-global financial crisis period, this may be the result of increased exposures to the sovereign which do not carry a risk weight. Once accounted for sovereign risk, capital buffers may be overstated.
• Fourth, empirical analysis documents the nexus in EMDEs and suggests that it has increased recently (Figure 3). Using a novel quantile regression framework, we estimate that the nexus sharply increases as sovereign stress rises (Figure 3, Panel A). Also, quantitative estimations suggest that banks’ public sector exposures are positively associated with the probability of default of financial institutions. Lastly, the estimated nexus indicator for the median EMDE has tripled since 2013 (Figure 3, Panel B).

Figure 2 - Banks’ claims on total government and public non-financial entities
(% of GDP) 2000-2017

Figure 3 - The Nexus between the Sovereign Sector and the Financial Sector in EMDEs

To minimize the adverse effects of the sovereign-bank nexus, it is important that policymakers focus their efforts on:

• First, maintaining fiscal and bank buffers which reduces both the probability and severity of stress emanating from each sector. For the sovereign this implies prudent fiscal buffers, effective revenue mobilization, and strong public debt and fiscal risk management, including prudent debt composition and contingent liabilities. For banks this suggests maintaining strong and transparent capital and liquidity buffers, particularly if the banking system is relatively large and contains systemic banks.
• Second, strengthening surveillance and supervision to identify and mitigate banking risks. Strong, risk-based macro- and micro-prudential frameworks are required to identify risks in banks’ financial conditions. However, EMDEs often lack those strong frameworks and face institutional constraints to apply effective supervision.
• Third, improving transparency and data quality of bank-sovereign linkages and contingent liabilities. For example, for the sovereign, a system of timely information about ownership linkages with state-owned enterprises and other sources of contingent liabilities should be implemented. For banks, disclosure requirements on all sovereign exposures should be in place, including how they are classified for accounting purposes.
• Fourth, addressing the sovereign exposures channel. This objective can be reached by considering measures to deal with the “excessive exposure” problem, including topics such as the preferential regulatory treatment of sovereign exposures, the home bias of bank portfolios, financial repression, and shallow financial sector development that create captive demand.
• Fifth, addressing the government support channel. For example, in countries with relatively large, bank-centric, or fast-growing banking systems, authorities should consider ex-ante measures to reduce moral hazard (e.g., by revisiting explicitly and implicit guarantees, including those associated with the “too big to fail” situation), and ex-post measures to reduce the severity of a crisis and tax payers’ exposure to losses.
• Sixth, considering policy tradeoffs carefully. Policy makers’ decisions about how to address the nexus should be carefully analyzed to avoid unintended consequences, such as the tightening of one of the channels that could generate deeper spillovers. For example, to weaken the sovereign exposure channel, policy makers may impose restrictions on sovereign debt exposures of domestic banks. However, this could affect important economic functions of sovereign debt markets including the transmission of monetary policy and bank’s liquidity management.

The Basel III capital and liquidity accords, the G20 “too big to fail” reforms, the Financial Stability Board’s Key Attributes for effective resolution frameworks for financial institutions, and the Basel Committee’s review of the regulatory treatment of sovereign exposures all offer relevant measures for EMDEs, but also pose implementation challenges in light of institutional capacity constraints and the level of economic and financial market development.