How does sovereign risk affect bank funding conditions? What can policymakers do?

Fabio Panetta, Michael Davies 26 July 2011

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The financial crisis and the subsequent recession have caused a sharp deterioration in public finances across advanced countries, raising concerns about sovereign credit risk. Sovereign risk is already a major issue in the Eurozone, where three countries have received international assistance, and others have seen their credit ratings lowered during 2009-11 and/or their funding costs rise.

Looking forward, a broader range of countries could be affected. In advanced economies, government debt levels are expected to continue to rise over the coming years. Japan was downgraded in early 2011, and the UK and US have been warned at various stages that they might lose their triple-A ratings. Overall, risk premia on government debt will likely be higher and more volatile than they were in the past.

On 11 July, the Committee on the Global Financial System – a Basel-based central-bank forum that monitors global financial stability – released a report that examines how an increase in sovereign risk affects bank funding conditions and discusses banks’ and policymakers’ options for mitigating the impact (see CGFS 2011). The findings of that report are summarised here.

Channels through which sovereign risk affects bank funding conditions

The rise in sovereign risk since late 2009 has increased the cost and weakened the composition of bank funding, with the extent of the impact on banks broadly in line with the perceived deterioration in the creditworthiness of the home sovereign. Banks in Greece, Ireland, and Portugal have seen their credit-default swap premia rise to extremely high levels, their issuance of short-term wholesale debt fall sharply, and their deposit costs rise. They have also become reliant on central bank liquidity. The increase in funding costs has spilled over to banks in other European countries, although to a much lesser extent.

The CGFS report identifies four main channels through which increases in sovereign risk affect bank funding conditions.

  • First, it causes losses on banks’ sovereign holdings. Banks generally show a strong home bias in their sovereign portfolios (Figure 1, panels A and B). In some countries (for example Belgium, Canada and Switzerland) they also hold significant quantities of foreign sovereign debt (panel C). Exposures to the sovereigns most severely affected by the current crisis are significantly smaller, but sometimes non-negligible (panel D).

  • Second, it reduces the value of the collateral that banks can use to secure wholesale and central bank financing. In private repo markets, sovereign debt accounts for a large share of total collateral, and participants are highly sensitive to changes in its riskiness. For example, in European repo markets, only 1.6% of transactions were collateralised by Greek, Irish, and Portuguese government bonds in the second half of 2010, less than half the share in 2008 and 2009. Sovereign debt is also widely used as collateral in central bank operations.
  • Third, it lessens the funding benefits that banks derive from government guarantees, be they explicit or perceived. The value of implicit support to banks by the weaker Eurozone countries, as assessed by ratings agencies, has decreased noticeably since late 2009 and is now quite low.1 Similarly, the value of explicit government support for banks (measured by the spread between the yields on a bank’s government-guaranteed and non-guaranteed senior bonds) tends to be higher in triple-A countries such as the Germany, France, the UK, and the US, than in non-AAA rated countries.
  • Fourth, sovereign downgrades often flow through to downgrades of domestic banks, thereby raising their wholesale funding costs and possibly reducing their market access. Rating triggers in derivatives contracts can also lead to margin calls on a bank that is downgraded.

Overall, these effects tend to increase banks’ funding costs (particularly for wholesale funding) and impair banks’ access to financial markets.

Reflecting growing financial integration and the close links among the financial markets of advanced economies, distress of one sovereign tends to spill over to other sovereigns and banks. Global interbank exposures are large for banks in most advanced economies. Banks also often have sizeable claims on non-bank private entities in foreign countries. Sovereign tensions can also spread among countries that are perceived to be vulnerable because they have some of the economic characteristics of the worst affected countries. These international spillovers have played a non-trivial role in the recent sovereign debt crisis in the Eurozone.

How banks might respond

Banks can mitigate the effects of rising sovereign risk by changing their operations, but there are trade-offs for them in doing so.

On the assets side, in an environment where sovereign debt is no longer risk-free, banks might further diversify the country composition of their sovereign portfolios to contain their over-exposure to the home sovereign. However, for some banking systems this implies a trade-off between sovereign risk and liquidity risk, as foreign sovereign debt may not be eligible to satisfy liquidity standards or as collateral in central bank and private repurchase agreements.

On the liabilities side, banks can protect themselves against funding risk from periodic bouts of (sovereign induced) investor risk aversion by increasing their use of more stable funding sources (such as deposits, long-term debt and equity), diversifying the timing of their debt issuance, and avoiding clustering of maturing wholesale debt. However, this may push up banks’ average funding costs (though not their “risk-adjusted” costs). Large cross-border banks might also diversify their debt issues across different jurisdictions through their subsidiaries.

Lastly, internationally active banks will need to pay greater attention to the public finances in countries in which they operate, as any worsening in sovereign risk in those countries could affect their branches or subsidiaries, with negative spillovers to the parent bank.

What can policymakers do?

The official sector also has a key role in minimising the impact of sovereign risk on banks. Though, again, there are tradeoffs.

The most important lesson is for governments. Because it is nigh impossible to protect the banking system from a distressed domestic sovereign, they must recognise that sound public finances are essential. Moreover, increasing financial integration means that international financial stability depends on the solidity of fiscal conditions in each individual country. Strong government finances are becoming a public good that each country supplies to other countries.

Second, bank supervisors need to monitor the interaction of sovereign risk with regulatory policies that encourage banks to hold large quantities of public debt. Moreover, during a crisis, when risk aversion is high, uncertainty about the banks’ assets (including sovereign portfolios) can create funding pressures for all banks. Depending on the specific circumstances, coordinated ad hoc disclosures of individual banks’ sovereign exposures may be beneficial.

Third, central banks might consider having flexible operational frameworks that, during severe crises, allow funding to be supplied to banks against a broad range of collateral to ease immediate liquidity pressures. However, this is not costless – it shifts credit risk to the central bank and encourages moral hazard – and so should be used sparingly and with appropriate safeguards.

Lastly, ongoing regulatory reforms that target the “too-big-to-fail” issue have an important role in reducing investors’ expectations of government support for banks, thereby helping to weaken the link between sovereigns and banks.

The bottom line is that deteriorating fiscal conditions have an adverse impact on the stability of banking systems at home and abroad. Fiscal authorities need to step up efforts to return public finances to more solid long-term paths. Banks, their supervisors, and central banks should act now to prepare for a sustained period of more volatile sovereign risk premiums. While it is impossible to fully insulate the banking system from a distressed domestic sovereign, everyone has a role in minimising the impact.

References

Committee on the Global Financial System (2011), The impact of sovereign credit risk on bank funding conditions, 11 July.

 


1 A proxy for implicit government support for banks is the difference between the “issuer rating” (the overall rating, which takes into account the likelihood of government or group support if a bank is in trouble) and the stand-alone rating, which reflects only the bank’s intrinsic strength.

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Topics:  Global economy International finance

Tags:  Fiscal crisis, Eurozone crisis, sovereign debt crisis

Head of the Department for Economic Outlook and Monetary Policy, Banca d'Italia

Michael Davies

Senior Economist, Bank for International Settlements

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