metadata: authors: 0: author: Feyen,Erik H.B.
1: author: Zuccardi,Igor
count: World
docna: 0: docna: The Sovereign-Bank Nexus in EMDEs : What Is
            It, Is It Rising, and What Are the Policy Implications ?
docty: Policy Research Working Paper
subtopic: Legal Institutions of the Market Economy,Financial Sector Policy,Macroeconomic Management,Economic Growth,Financial Structures
teratopic: Public Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: This paper explores the sovereign-bank
            nexus in emerging markets and developing economies: the
            interconnectedness between the health of the sovereign and
            the banking system. Data from 140 emerging markets and
            developing economies suggest that this nexus is rising.
            First, banks have increased their exposure to their
            sovereigns in the past decade. Second, government debt has
            grown, and fiscal positions have deteriorated, raising the
            specter of sovereign stress. Third, banking system assets
            and bank credit to the private sector have steadily
            increased, which may restrict the sovereign's capacity
            to contain a banking crisis. Fourth, empirical evidence from
            36 emerging markets and developing economies documents the
            existence of the nexus and suggests that it has increased
            recently. However, deeper country analysis is required for a
            better understanding of the sovereign-bank nexus, given
            country idiosyncrasies, including the structure of sovereign
            debt and the composition of the investor base, and data lags
            and opacities. To minimize the adverse effects of the
            sovereign-bank nexus, efforts should be focused on
            maintaining fiscal and bank buffers, strengthening
            surveillance and supervision of the banking system,
            improving transparency and data quality of bank-sovereign
            linkages, better addressing the regulatory treatment of the
            sovereign exposures and government support of the banking
            sector, and carefully evaluating the policy trade-offs in
            the sovereign-bank nexus.
repnme: repnme: The Sovereign-Bank Nexus in EMDEs : What Is
            It, Is It Rising, and What Are the Policy Implications ?
display_title: The Sovereign-Bank Nexus in EMDEs :
            What Is It, Is It Rising, and What Are the Policy Implications
listing_relative_url: /research/2019/07/31291409/sovereign-bank-nexus-emdes-rising-policy-implications
topicv3: Monetary and Financial Stability m1327169 1098,Central Banks m1327453 1235,Monetary Policy m1327609 444,Financial Sector Development m1327681 1920,Financial Institutions m1505015 3797
publishtoextweb_dt: 2019-07-30T00:00:00Z
historic_topic: Public Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 52
author_keys: 0: author_key: 783512
model_extractions: Policy Research Working Paper 8950 The Sovereign-Bank Nexus in EMDEs What Is It, Is It Rising, and What Are the Policy Implications?

_Erik Feyen Igor Zuccardi_ Finance, Competitiveness and Innovation Global Practice July 2019
Policy Research Working Paper 8950

# **Abstract**

This paper explores the sovereign-bank nexus in emerging markets and developing economies: the interconnectedness between the health of the sovereign and the banking system. Data from 140 emerging markets and developing economies suggest that this nexus is rising. First, banks have increased their exposure to their sovereigns in the past decade. Second, government debt has grown, and fiscal positions have deteriorated, raising the specter of sovereign stress. Third, banking system assets and bank credit to the private sector have steadily increased, which may restrict the sovereign’s capacity to contain a banking crisis. Fourth, empirical evidence from 36 emerging markets and developing economies documents the existence of the nexus and suggests that it has increased recently. However, deeper country analysis is required for a better understanding of the sovereign-bank nexus, given country idiosyncrasies, including the structure of sovereign debt and the composition of the investor base, and data lags and opacities. To minimize the adverse effects of the sovereign-bank nexus, efforts should be focused on maintaining fiscal and bank buffers, strengthening surveillance and supervision of the banking system, improving transparency and data quality of bank-sovereign linkages, better addressing the regulatory treatment of the sovereign exposures and government support of the banking sector, and carefully evaluating the policy trade-offs in the sovereign-bank nexus.

This paper is a product of the Finance, Competitiveness and Innovation Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at efeijen@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **The Sovereign‐Bank Nexus in EMDEs: What Is It, Is It Rising, and What Are the Policy Implications?**

Erik Feyen<sup></sup> Igor Zuccardi JEL Classification Numbers: F34, F65, G21.

Keywords: Sovereign‐bank nexus, fiscal balance, public debt, bank exposure, probability of default, Emerging and Developing Economies.

 Erik Feyen is Head of Macro‐Financial Unit and a Lead Financial Economist in the World Bank’s Finance, Competitiveness, and Innovation (FCI) Global Practice. Igor Zuccardi is a Financial Economist in the Macro‐Financial Unit.

The views expressed in this paper are those of the authors and do not necessarily reflect those of the World Bank. This paper first appeared as a Special Topic in the October 2018 issue of the _Macro‐Financial Review_ report which is co‐produced by the Finance, Competitiveness and Innovation (FCI) and Macroeconomics, Trade, and Investment (MTI) Global Practices under the auspices of the Equitable Growth, Finance and Institutions (EFI) Vice Presidency. We are grateful to Paloma Anos Casero, Mariano Cortes, Doerte Doemeland, Alfonso Garcia Mora, Nigel Jenkinson, Lars Jessen, Naoko Kojo, Bill Maloney, and members of the Financial Stability Board’s Analytical Group on Vulnerabilities for discussions and comments. We thank the following Focal Points of the _Macro‐Financial Review_ for regional perspectives which are reflected in Box 5: Ana Maria Aviles and Richard Record (East Asia and Pacific region), Eva Gutierrez, Raquel Letelier, Alena Kantarovich, and Elisa Gamberoni (Europe and Central Asia region), Syed Mehdi Hassan and Emmanuel Pinto Moreira (Middle East and North Africa), and Marius Vismantas and Muhammad Waheed (South Asia). Box 6 and Box 7 are in part based on work by Krishnamurti Damodaran and Barend Jansen, respectively. We also thank Federico Diaz Kalan for assistance with the data, and Diego Sourrouille and Jiemin Ren for research assistance. For questions, please contact the authors at efeijen@worldbank.org and <u>izuccardi@worldbank.org.</u>
# 1. Introduction and overview

This paper explores the sovereign ‐ bank nexus in emerging markets and developing economies (EMDEs), which 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. We identify two _direct_ channels (bank’s direct exposures to the sovereign and government support to failing banks) and two _indirect_ channels (fiscal and bank interactions with the real sector).

Our analysis of data from 140 EMDEs seem to suggest that the sovereign‐bank nexus is rising, but deeper country analysis is required given country idiosyncrasies, including the structure of sovereign debt and the composition of the investor base and data lags and opacities. First, banks have increased their exposures to their sovereign in the last decade, both relative to their balance sheets and country GDP – this tightens the exposure channel. The median banking system has seen its total exposures to government and non‐financial public entities more than double since 2007 (current median: 8% of GDP). Regressions for 36 EMDEs suggest this factor is also positively associated with the probability of default of financial institutions. Further, banks’ sovereign securities holdings as a fraction of banking system assets have doubled as well (current median: 10% of assets). Second, government debt has grown, and fiscal positions have deteriorated, raising the specter of sovereign stress, particularly in an environment of tightening global financial conditions ‐‐ this tightens all direct and indirect channels and may activate the nexus. Third, banking systems assets and bank credit to the private sector have steadily increased which may restrict the sovereign’s capacity to contain a banking crisis – this tightens the government support channel. However, bank buffers have improved during this period as well. Yet, this may be the result of larger exposures to the sovereign which do not carry a risk weight. Capital buffers may thus be overstated. Fourth, empirical evidence documents the existence of the nexus in EMDEs and suggests that it has increased recently. Using a novel quantile regression framework, we estimate that historically, the nexus increases sharply as sovereign stress increases in EDMEs. Also, regressions suggest that banks’ exposures to the public sector are positively associated with the estimated probability of default of financial institutions. Lastly, the estimated nexus for the median EMDE has tripled since 2013: a one‐percentage point increase in the probability of 2
default of financial institutions is currently associated with a 120‐basis points increase in the EMBI spread.

To minimize the adverse effects of the sovereign‐bank nexus, our results imply that policy makers should focus their efforts on: First, _maintaining fiscal and bank buffers_ which reduces both the probability and severity of stress emanating from each sector. The measures proposed in the Basel III capital and liquidity framework aim to strengthen bank buffers and many EMDEs aim to adopt them, notwithstanding various implementation challenges. Second, _strengthening surveillance and supervision_ to identify and mitigate risks in the banking system, since bank stress often emanates from rapid credit growth, weak underwriting standards, and regulatory forbearance. Third, _improving transparency and data quality of bank‐sovereign linkages and contingent liabilities_ not only for surveillance and prudential purposes, but also since during times of stress, investors may assume the worst and indiscriminately act with excessive risk aversion which may amplify stress. Fourth, _addressing the sovereign exposures channel_ by considering measures to deal with the preferential regulatory treatment of sovereign exposures, the home bias of bank portfolios, and financial repression and shallow financial sector development in some EMDEs which creates a captive demand for sovereign debt which may weaken fiscal discipline. Fifth, _addressing the government support channel_ by considering i) ex ante measures to reduce moral hazard and the probability of a crisis and ii) ex post measures to reduce the severity of a crisis and protect tax payers such as proposed in the G20 “too big to fail” reform agenda and the FSB’s _Key Attributes_ for effective resolution frameworks. Again, EMDEs face various implementation challenges. And lastly, _considering policy trade‐offs carefully_ to avoid an unintended tightening of one of the channels which could generate deeper spillovers **.** For example, to weaken the sovereign exposure channel, policy makers may impose restrictions on sovereign debt holdings. However, poorly calibrated risk weights could prove to be pro‐cyclical. As another example, to weaken the government support channel, policy makers may try to adopt explicit measures that rule out any support. This could trigger unintended contagion that leads to a deeper crisis with larger social losses.

The Basel III capital and liquidity accords, the Basel Committee’s review of the regulatory treatment of sovereign exposures (Box 6), the G20 “too big to fail” reforms, the Financial Stability 3
Board’s _Key Attributes_ for effective resolution frameworks (Box 7), and all offer relevant measures for EMDEs in this context, but also pose implementation challenges in light of institutional capacity constraints and level of economic and financial market development.

This paper is organized as follows. Section 2 describes the conceptual framework of the sovereign‐bank nexus. Section 3 discusses whether the nexus is rising based on data from 140 EMDEs. Section 4 offers six policy implications. Box 5 offers a selected, high‐level overview of relevant developments across regions.

# 2. What is the nexus? A conceptual framework

Conceptually, the sovereign‐bank nexus links the health of the domestic sovereign and the banking system together through two direct and two indirect channels (Figure 1).<sup>1</sup> Depending on national circumstances, the sovereign – bank nexus can act as a shock absorber or amplifier and foreign investors may play a role as well (Box 3). There are two _direct channels_ :

1. _Banks’ direct exposures to the sovereign._ Direct exposures to the sovereign make banks’ balance sheets vulnerable to losses on government assets holdings (e.g., through lending to the public sector and holdings of securities issued by the public sector). Conversely, if banks expand their sovereign exposures, they could help the sovereign to overcome temporary fiscal stress.

2. _Government support to failing banks._ The sovereign is often implicitly expected to support failing banks, particularly those that are systemically important, because it cannot credibly commit ex ante to refrain from doing so during a crisis. This “time inconsistency” bestows funding and other stability benefits on systemic banks. However, it may also lead to excessive risk taking by banks (i.e., moral hazard) and expose taxpayers to losses.

> 1 Sovereign debt is understood to mean the sum of money borrowed by a country’s central government.  However, this section refers to “sovereign” more broadly as a country’s public sector (including key state‐owned enterprises) due to its implications for the domestic financial system.

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Clearly these two channels may interact and give rise to feedback dynamics in which sovereign distress amplifies bank distress and vice versa.<sup>2</sup> For example, adverse changes in sovereign distress imposes losses on banks which may raise the need for government support to ailing banks exactly at the time the sovereign’s capacity to do so is more constrained. Further, prospects of weaker capacity for government support may make markets and depositors more reluctant to fund banks which raises funding costs and may weaken banks further. Conversely, a banking crisis may make government support inevitable which can trigger or increase sovereign distress and impede its ability to improve its funding structure to manage its risks. As fiscal space erodes, the government’s capacity to provide countercyclical support to real sector activity is diminished. However, when bank and fiscal buffers are adequate, the nexus may also serve as a shock absorber and avoid escalation.

In addition, there are _two indirect channels_ through which the nexus affects the domestic real economy and worsen the economic outlook, increase risk premia, and reduce asset prices with adverse stock and flow effects for all sectors in the economy ‐‐ these interactions are complex with causality running in opposite directions: 3. _Fiscal ‐ real sector interactions._ Sovereign distress requires fiscal consolidation and other structural measures which could dampen economic activity. This, in turn, lowers tax revenues, raises sovereign funding costs, and triggers automatic stabilizers which will weaken fiscal conditions further. In turn, higher sovereign risk premia spill over to tighter financing conditions for the real sector which curtails economic activity.

4. _Banking ‐ real sector interactions._ Bank distress raises their funding costs and inhibits banks from extending credit to the real economy which slows down economic activity. This, in turn, will weaken bank balance sheets further through an increase in non‐ performing loans, more fragile and expensive funding profiles, and lower valuations.

> 2 Sovereign distress is a loosely defined term which describes a situation in which the sovereign is facing rollover, refinancing, and debt servicing difficulties, typically the result of a material (perceived) deterioration of sovereign debt portfolio risks. Factors that could precipitate such conditions include an erosion of fiscal and foreign exchange reserve buffers, and sharp increases in global risk premia. Under a sovereign distress scenario, the market value of (tradeable) sovereign debt falls materially. This may deepen sovereign distress further as risk premia rise and sovereign funding markets may become dislocated. Extreme distress may lead to outright default or restructuring.

5
History has shown that banking and sovereign crises can occur together in both advanced economies and EMDEs (Reinhart and Rogoff, 2009; Gennaioli et al, 2014; Dell’Ariccia et al, 2018). Before the Euro‐area sovereign debt crisis, the threat of sovereign defaults was mostly regarded as a problem of EMDEs. Indeed, no advanced economy defaulted on its domestic debt between 1950 and 2010. However, the recent Euro‐area crisis highlighted the nexus’ powerful effects on domestic credit expansion and economic activity and paved the way for extraordinary policy interventions which comprised massive central bank liquidity support, a government bond purchasing program, and the creation of a resolution fund to sever the “doom loop” between banks and sovereigns (see Box 1). In the late 1990s and early 2000s the nexus also figured prominently during various financial crises in EMDEs (e.g., Ecuador, Dominican Republic, the Russian Federation, and Argentina). In some cases, government debt had soared in the wake of bank stress episodes and subsequently required restructuring. In others, governments increasingly relied on banks to fund deteriorating fiscal positions which made a banking crisis unavoidable after the eventual sovereign default.

Laeven and Valencia (2018) documented the number of banking and sovereign crises in EMDEs between 1970 and 2017 (Table 1). The number of crises (either sovereign or banking) is 196, mainly in Sub‐Saharan Africa (AFR with 66 episodes), Latin America and the Caribbean (LAC with 61 episodes), and Europe and Central Asia (ECA with 41 episodes). Some of those cases might reflect the nexus between the sovereign and the banking sectors: First, the number of crisis episodes in which a banking crisis is followed by a sovereign crisis in a 3‐year window period is 9 (4.8% of total cases), particularly concentrated in LAC, with 5 cases. Second, the number sovereign crises followed by banking crises in a 3‐year window period is 2 (1.08% of total cases), concentrated in AFR. Third, the number of sovereign and banking crises starting simultaneously is 10 (5.4% of total cases), especially in LAC, AFR, and ECA. Therefore, in 11.3% of total crisis episodes, sovereign and banking crises occurred (almost) together.

In the decade since the Global Financial Crisis, the creditor profile of public sector debt has changed considerably in several EMDEs which has increased the likely potency of the sovereign‐ bank nexus. While many governments tapped international capital markets on the back of low international interest rates, their reliance on domestic borrowing to finance deficits has also risen 6
and is likely to grow further in the near term as foreign investors lower exposures to these markets driven by, among others, rising interest rates in developed markets.

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

<!-- Start of picture text --> Sovereign &<br>• Lower tax revenue Central Bank<br>• Weaker economic<br>growth • Higher cost of<br>2 sovereign & SOE<br>• Higher bailout debt distress<br>costs • Higher funding<br>3 • Higher costs<br>funding costs • Weaker<br>• Procyclical backstops<br>monetary and<br>fiscal measures 1<br>• Arrears<br>Tighter lending and<br>funding conditions<br>Real sector Banks<br>4<br>• Increasing cost of non‐<br>performing exposures<br>• Increasing funding costs<br>• Increasing rollover and funding risks<br>• Currency depreciation<br>Increasing credit and market risk • Depletion of currency reserves<br>Foreign investors<br><!-- End of picture text --> 7
# **Box 1: The Euro‐area debt crisis and the sovereign‐bank nexus**

# **Context**

The Euro‐area debt crisis led to financial market fragmentation and revealed the flaws of an incomplete currency union in which responsibility for financial stability remains _de facto_ national. The 2010‐12 European debt crisis erupted before the Euro area could recover from the global financial crisis and was characterized by overly high government structural deficits and accelerating public debt levels. During 2012‐16, the average consolidated public debt to GDP ratio of the EU‐28 slightly decreased from 83.9% to 83.3% and subsequently 81.6 % of GDP in 2017. The Euro area also faced a wave of defaults by property developers and homeowners. Loan defaults, structural revenue shortfalls, and the currency union’s incomplete architecture left many Euro area economies with the challenges of managing liquidity risk, establishing fiscal sustainability, and addressing a tightening the sovereign – bank nexus.

To strengthen their balance sheets, EU banks had received guidance to improve their risk‐ weighted capital ratios. This was perhaps a contributing factor for banks to increase their sovereign debt holdings further. Despite having passed stress tests conducted by the Committee of European Banking Supervisors, banks in some countries continued to struggle with large impaired assets and nonperforming loans. Concerns also emerged that the stress tests did not fully incorporate sovereign default risk. Based on data from the European Banking Authority, sovereign exposures of large banks in the Euro area: i) did not change substantially between end‐2013 and mid‐2015; ii) banks still invest more than their own funds in sovereign debt; and iii) banks’ sovereign debt holdings exhibit a strong home bias, particularly in the southern European countries and in Germany.

# **Crisis management**

Crisis responses include: _ECB liquidity and credit support_ through traditional and unconventional facilities aimed at avoiding market dislocations; _European Financial Stability Facility_ (EFSF) was created to assist Euro area sovereigns for the resolution of difficulties in their banking systems; _The Outright Monetary Transactions (OMTs)_ framework of the ECB was designed to address distortions in sovereign bond markets and thereby increase the effectiveness of monetary policy; the creation of the _European Stability Mechanism (ESM)_ firewall fund; and _official loan maturities to program countries_ (e.g., Greece and Cyprus).

# **Towards a banking union**

The crisis spurred efforts to build a banking union with a common supervisory framework, a pan‐European deposit guarantee scheme, and a bank resolution authority to break the adverse loops between sovereigns and banks and protect taxpayers. These efforts have resulted in, _inter alia_ , the adoption of the Bank Recovery and Resolution Directive (BRRD) and the Single Resolution Mechanism Regulation (SRMR), the Single Supervisory Mechanism (SSM) and the 8
Single Resolution Mechanism (SRM). However, the banking union remains incomplete. There is still a need to expedite the implementation of “bail‐in‐able” debt, strengthen the operational capacity of the resolution authority, and create proper pan‐European burden sharing (e.g., pan‐European deposit insurance).

## **Systemic Risk Buffer**

In the EU context, a carefully calibrated and gradual Systemic Risk Buffer (SRB) was considered by the FSAP to be the preferred policy measure to mitigate the risks of the sovereign‐bank nexus. Unlike the use of positive risk weights on sovereign exposures, the SRB is legally possible under the current European Capital Requirements Regulation (CRR) framework, and it avoids procyclicality. The use of the SRB builds capital buffers preemptively and allows for the possibility to relax them during periods of stress. Unlike applying large exposure limits on sovereign exposures, the SRB is a price‐based measure, and does not entail the risk of potentially strong and detrimental “cliff‐effects” in the manner that such quantitative restrictions do.

# 2.1. Two direct channels: Exposure to the sovereign and government support

## _A. Exposure to the sovereign: Direct transmission of sovereign stress to banks_

Direct debt exposures to a fragile domestic sovereign pose various risks to banks including credit, interest rate, market and refinancing risk. These risks, in turn, weaken bank balance sheets which reduces income and raises the cost and availability of funding through higher sovereign and bank risk premia which leads to a further deterioration of balance sheets and funding profiles. In this context, important factors to consider, include:

**Losses on sovereign debt exposures.** Banks hold sovereign bonds for a variety of reasons (Box 2). Due to a strong home bias for most banks, their equity value and solvency depend on the (perceived) solvency and market value of their own government’s debt. The nature of the impact depends on whether the securities were held at market value or amortized cost. The latter is the case for most EMDEs which implies that losses crystallize when the bonds become impaired (e.g., due to default or restructuring). However, banks that hold government debt in their trading books are exposed to interest rate risk (particularly if risk premia rise) if there is a duration mismatch which can occur if their funding is mostly short‐term such as through sight deposits, a

9
common feature in EMDEs. Banks can also be exposed to sovereign risk through over‐the‐counter derivative positions vis‐à‐vis the sovereign, although these markets are limited in most EMDEs.

**Reliance on domestic banks to finance growing fiscal deficits.** Public borrowing often increases sharply ahead of sovereign debt crises which tightens the nexus. Indeed, during fiscal stress, the government may rely on banks financing by issuing bonds at higher yields, particularly in countries with undiversified financial systems.

**Weaker public backstops.** Implicit and explicit government guarantees improve banks’ funding positions, particularly for those that are considered “systemic”. The resulting mispricing may lead to excessive risk taking by these banks (i.e., moral hazard). However, the (perceived) value of these guarantees and other forms of crisis support to systemic and non‐systemic banks will fall in case of sovereign distress even prior to outright default or restructuring. This raises funding costs and depresses valuations of all banks even prior to outright sovereign default or restructuring.

**Collateral and liquidity effects.** Besides direct net present value losses due to restructuring or outright default, during periods of sovereign distress, government bond markets may not always be liquid which impedes banks to manage their balance sheets and liquidity and raises their cost and worsen risk profiles. Further, sovereign stress will adversely affect the value of government debt as collateral such as through repo transactions with the central bank or other banks and may raise funding costs and liquidity needs. For example, market losses on government securities may trigger margin calls and larger haircuts. Furthermore, as yield curves on the sovereign are used as reference to price private risks, jumps in yield directly increase the funding costs of private sector borrowers.

**Financial repression and flight to safety.** In attempt to close fiscal gaps, sovereigns (typically through sector regulators) may require banks (and also non‐financial entities such as insurance companies, pension funds, and National Savings Schemes) to hold minimum levels of government bonds, possibly at non‐market terms. This mutes the disciplining role of the rising sovereign risk premia and weakens profitability and solvency of the investors. This is a highly risky strategy which tightens the sovereign‐bank nexus at exactly the wrong time, besides introducing pricing

10
and resource allocation distortions to the system. To the extent possible, banks often respond by reducing maturities of their government bond holdings. However, banks may also voluntarily choose to tilt their portfolios to government debt since they still represent the safest and most liquid asset in the economy, even during times of sovereign stress.

**Non‐performing exposures to state‐owned enterprises (SOEs).** In many EMDEs, SOEs often represent the most viable and secure credit exposures for banks, particularly for state‐owned banks. Moreover, SOEs can benefit from preferential regulatory treatment (e.g., through lower risk weights for bank exposures) and the perception of a government guarantee. However, sovereign and SOE stress may co‐occur in countries with a narrow economic and tax base such as commodity exporters. SOE payment arrears including on banking debt is a typical telling sign of distress.

**Sovereign credit rating downgrades.** Sovereign ratings typically impose a ceiling on domestic credit ratings, including of banks. Sovereign downgrades thus may trigger downgrades of banks themselves which raises their funding costs and even impair market access, posing profitability, funding, and liquidity challenges. Bank downgrades may also produce “cliff effects” as domestic institutional investors may be required to only hold high‐quality exposures and will be forced to liquidate. However, the credit rating channel may not operate in some developing countries due to a lack of ratings for banks.

**Outflow of sovereign and SOE deposits.** The government and SOEs are often large bank depositors in EMDEs, particularly in state‐owned banks. A sovereign or SOE in distress may be forced to withdraw (foreign currency) deposits and thus put liquidity pressure on the banks which may weaken their balance sheets further.

11
# **Box 2: Why do banks hold sovereign debt?**

Sovereign debt plays an important role in the economy ‐‐ including for monetary policy, asset pricing, and financial market development ‐‐ and central government debt markets are typically the deepest and most liquid. Banks hold government securities for:

- _Balance sheet and liquidity management._ Banks use sovereign debt to manage liquidity and as collateral for credit risk mitigation (e.g., repo transactions).

- _Regulation and financial repression._ Banks are incentivized to hold sovereign debt due to a preferential capital and collateral treatment, lack of large exposure limits, and the need to comply with prudential liquidity standards. In some jurisdictions, banks are required, or strongly persuaded, to hold a minimum fraction of their balance sheets in the form of sovereign debt. This could support the sovereign debt market development but also easily lead to undisciplined and mis‐priced financing of fiscal deficits.

- _Market making and investment._ Primary dealers and market makers naturally hold sovereign debt and play an important role in the transmission of monetary policy. Sovereign debt instruments may prove attractive investments, particularly when interest rates are high (leading to “crowding out” effects) or a lack of “bankable” projects in the economy – the quality of the regulatory and business environment plays a crucial role and is often weak in EMDEs.

- _Lack of alternative investments._ In countries with undiversified economies, shallow financial markets, and a poor enabling environment that can support sustainable credit intermediation (e.g., poor business climate, weak creditor rights), banks often decide to keep their funds at the central bank and in government securities.

# _B. Government support: Direct transmission of bank stress to the sovereign_

Governments and central banks have explicit arrangements (with safeguards in place) to support ailing, albeit in principle solvent, banks in well‐circumscribed conditions such as Emergency Liquidity Assistance. However, there is also a large implicit guarantee to the banking system due to a time inconsistency problem: governments are typically not able to credibly commit _ex ante_ from abstaining to provide support to distressed banks ‐‐ particularly during banking crises or a failure of a systemically important institution (i.e., those which are “too big to fail”) ‐‐ since support is the optimal response _ex post_ . This guarantee may also lead to excessive risk taking by banks which makes bank stress more likely in the first place (i.e., moral hazard). In this context, important factors to consider, include: 12
**“Bail outs”.** As banking stress increases, economic actors anticipate bailouts which triggers an increase in risk premia and market volatility which will inhibit the sovereign’s ability to fund itself and improve its risk profile. Rescue operations that stem from the implicit guarantee consist of massive liquidity support, bank recapitalizations, asset purchases, and funding of bank resolutions. During a banking crisis, implicit guarantees may become explicit such as through “blanket” government guarantees of bank liabilities in the hope to stem market panic and reduce financial stress.<sup>3</sup> This will only work if the guarantee is credible which is a function of three factors: i) the overall size (and hence effectiveness) of the guarantee, ii) the government’s perceived resolve to carry out the guarantee; and iii) the perceived fiscal capacity to support the guarantee. These guarantees create major contingent liabilities for the government, but no upfront costs. And if credible, these guarantees are often not called.

**Deposit insurance.** When a bank fails and is liquidated, insured deposits will need to be paid out. Although in many jurisdictions deposit insurers are funded by industry, there is a residual risk that simultaneous failure of multiple banks will require a backstop through for example a stand‐ by facility from the government.

**Central bank liquidity assistance.** Central banks provide liquidity to distressed, but otherwise solvent banks. To protect themselves against credit risk, central banks require collateral. However, in practice, distressed banks may have already sold their high‐quality collateral to improve their liquidity profiles before turning to the central bank. This may require the central bank to loosen collateral requirements and assume some credit risk, particularly in periods of systemic stress. It is not uncommon that to try preserve central bank independence and the integrity of its balance sheet, the monetary authority would ask for an indemnity from the fiscal authority before providing liquidity support to distressed (systemic) financial institutions. Such indemnity and/or credit line to the central bank may also directly expose the Ministry of Finance to losses.

> 3 Blanket guarantees have also been extended to shadow banks (e.g., money market funds) to short circuit the disruptions that can befall banks if those mutual funds experience a run.

13
**Higher funding costs for the sovereign and impaired transmission of monetary policy.** Banks are an important source of funding for sovereigns and SOEs and a prime conduit of monetary policy. However, distressed banks may be limited in their capacity to do so which may impair liquidity conditions in sovereign bond markets. Combined, these factors may produce in higher risk premia and lower quantities which increases sovereign funding costs and rollover risks. Consequently, central banks will likely try to intervene to support market function.

**Public ownership of banks.** State banks are typically owned outright by the official sector (e.g., Ministry of Finance, Ministry of State Assets) or indirectly through a holding company. As such, the sovereign is exposed to losses in state banks through reduced dividends and lower valuations of its equity holdings. This could impose fiscal challenges if state banks are very large. Moreover, state banks are typically perceived to have stronger government support through implicit and explicit government guarantees. Furthermore, when these banks operate as the main funding provider in economic sectors deemed critical by the authorities (e.g. housing, agriculture) the political pressure to recapitalize these entities would be strong.

**Transparency of bank balance sheets.** During periods of sovereign stress, risk aversion is high. Uncertainty surrounding the composition of bank balance sheets may lead investors to assume the worst which may trigger indiscriminate funding stress and loss of market access. In many EMDEs, bank balance sheets lack transparency, including the extent of direct and indirect exposures to governments and SOEs.

**Credit guarantees.** Many EMDEs have government‐supported credit guarantee schemes in place to support the extension of loans to strategic sectors (e.g., PPPs, infrastructure, mortgages, small firms, certain industries). This exposes the government directly to losses on these loans. Moreover, if the government is not able to cover the losses, banks will be forced to absorb them.

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# 2.2. Two indirect channels: Sovereign and bank interactions through the real sector

Sovereign distress and banking system distress independently interact with the real economy through adverse feedback loops which cause deeper distress in these respective sectors. In turn, lower economic activity and a worsening economic outlook adversely interact as well since households and firms will curtail consumption and investment in anticipation of more difficult times. More broadly, these channels can be amplified by currency depreciation, higher inflation, and monetary tightening.

## _A. Fiscal ‐ real sector interactions_

**Lower expenditures.** A deterioration of the fiscal outlook will lead to fiscal measures such as tax increases and spending reductions which reduce economic activity, thus lowering household and firm incomes. This may lead to a deeper reduction in tax revenues and further undermine the fiscal position.

**Government and SOE arrears.** In EMDEs, lower expenditures and weaker fiscal positions may trigger payment arrears of government contractors. This reverberates throughout supply chains resulting in liquidity and repayment strains on firms which weakens their creditworthiness and their appetite to invest. These effects tend to be large in undiversified economies where the state plays a large role such as in commodity exporters.

**Crowding out effects.** Growing sovereign stress likely triggers more government debt issuance at increasingly higher yields to attract investors which are typically banks. This crowds out the private sector, tightens financial conditions, and reduces economic activity. It also strengthens the nexus.

**Debt monetization** . The central bank could finance ballooning deficits directly or by offering short‐term refinancing to banks which invest the liquidity in government securities. Regardless, this practice exposes the economy to inflation and currency risks.

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# _B. Banking system – real sector interactions_

**Higher non‐performing loans.** Weaker economic activity will translate into higher non‐ performing loans by both firms and households which will increase bank distress through balance sheet and liquidity effects. Currency depreciation may exacerbate non‐performing loan volumes through currency mismatches.

**Bank credit “crunch”.** Bank distress ‐‐ in the face of weak capital buffers insufficient to handle shocks‐‐will impede banks’ appetite and ability to extend credit to the real sector thus leading to tighter lending conditions. This will curtail investment and consumption which dampens the economic outlook. However, while financial systems are bank‐centric in many EMDEs, credit intermediation is still relatively low which would reduce the impact of a credit crunch. Instead these banks prefer to remain liquid and often invest in sovereign debt.

**Bank runs.** The specter of a “run” by depositors or wholesale creditors is considerable during periods of severe bank stress. A run will put immediate liquidity and funding pressures on banks which deepens the distress and further inhibits their appetite and capacity to lend to the real sector. However, even prior to an actual bank run, distressed banks most likely will have already faced an increase in funding costs and challenges to improve their liquidity profiles which had accelerated stress.

**Asset prices.** A deteriorating economic outlook often goes hand in hand with weaker asset prices, including of real estate. Banks are directly affected to the extent that they hold such assets in their books and/or they provide the financing of real estate developers that see their net worth and debt servicing capacity worsen. This may trigger a “fire sale” cycle which further depresses asset prices and liquidity. However, in EMDEs this channel is limited in the absence of deep financial markets. There is also a collateral effect, particularly through mortgages. As real estate prices fall and mortgage defaults rise, banks will have difficulty to liquidate the real estate collateral and recoup their losses.

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# **Box 3: The role of foreign investors in the sovereign – bank nexus**

Foreign investors can play an important role in the nexus when they hold significant claims in the economy, particularly if these are short term. Given relatively shallow local financial markets in most EMDEs, foreigners often hold external debt denominated in foreign currency of the sovereign and large corporations which exposes these entities to international financial conditions. According to the IIF (2018), currently over 50% of government debt is held by foreigners in Indonesia, Peru, Ukraine, Colombia, Romania, and Uruguay. In addition, countries such as Argentina, Saudi Arabia, Turkey, Poland, Colombia, and Indonesia have more than 30% of their public debt denominated in foreign currency.

**Diversification of government debt investor base.** In their search for yield, foreigners have increasingly been holding local currency sovereign and corporate debt in various EMDEs. This diversification may reduce the potency of the nexus. However, as global interest rates are currently rising, foreigners may retrench to home markets which will strengthen the nexus again if banks will step in.

**Risks of “sudden stops”.** Foreign investors may be less patient than domestic investors and behave in a procyclical manner when faced with a (perceived) increase in sovereign credit and market risk which leads to more volatility. This may trigger a sharp reduction in capital inflows causing the materialization of rollover risks and higher funding costs for sovereigns and the real sector alike. This, in addition to adverse currency movements, will weaken their balance sheets. Credit rating downgrades may produce “cliff effects” which may accelerate this process. Further, if the domestic government bond market is not very deep, sudden portfolio shifts by foreign investors could also trigger sharp price corrections in government debt and hence impose substantial losses on the trading books of banks.

**Macro‐economic effects.** The usual macro‐economic impacts of sudden stops could trigger large currency depreciations which amplify currency mismatches and lead to loss of foreign reserves. Further, lower, more volatile asset prices may strengthen all sovereign – bank nexus channels mentioned earlier. For example, there is the potential for sudden spikes in exchange rates as foreign investors “run” to convert local currency proceeds into foreign exchange. The impact could be substantial in financially dollarized banking systems both directly and indirectly through unhedged borrowers.

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# 3. Is the nexus rising in EMDEs? A first look at the data

## 3.1. Deterioration of fiscal conditions across all regions

EMDE central government debt has increased significantly across all regions, particularly in Sub‐ Saharan Africa (AFR) and Middle East and North Africa (MENA) (Figure 2, A and B). EMDE government debt reached US$14 trillion in 2017 (48% of GDP), rising from US$8 trillion in 2010. EMDE medians tell a similar story: In 2007, at the start of the global financial crisis, median general government debt to GDP stood at 35.3% and has risen to 49.3% in 2017 ‐‐ it is as high as 66.8% to GDP for poor performers (75<sup>th</sup> percentile). This pattern is consistent across all regions. In particular, debt levels are high and rising in many low‐income countries, many of them in AFR where the median currently stands at 54%. Further, median debt is in excess of 65% in MENA and South Asia (SAR) and poor performers in MENA even breached 100%.

In tandem, there is a broad‐based and consistent deterioration of the fiscal balance in EMDEs, although conditions have improved slightly since 2016 (Figure 2, C and D). In 2007, the median fiscal position for EMDEs was ‐0.7% of GDP but deteriorated quickly in the wake of the crisis reaching a nadir in 2009 of ‐3.6% before recovering. However, since 2012, the median fiscal position has deteriorated further and stood at ‐2.9% to GDP in 2017, a 0.4 percentage point improvement compared to 2016. Particularly poor performers (25<sup>th</sup> percentile) are currently faced with deficits of 5.4% to GDP. In all regions, except Europe and Central Asia (ECA), the median deficit is at least 2% of GDP – deficits are more than 4% in AFR, SAR, and MENA.

While reflecting a smaller country sample, the evolution of EMBI spreads tell a consistent story (Figure 2, E and F).<sup>4</sup> The median spread reached a decade high in 2016 of 414 basis points but fell by about 100 basis points in 2017.Widening spreads suggest a tightening of external funding conditions over and above an increase in global interest rates. This is both a reflection of weaker international investors’ risk appetite as well as their assessment of external sovereign debt

> 4 The EMBI spreads are a widely followed benchmark of the weighted yield of dollar‐denominated sovereign bonds over US government debt securities of about 36 emerging markets.

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sustainability. In 2017, the median EMBI spread stood at 310 basis points over US bonds, down from a decade‐high in 2016 of 414 basis points. It is currently around 340 basis points.

In this context, the Global Economic Prospects Report (June 2018) highlighted the need for EMDE policymakers to rebuild monetary and fiscal policy buffers and be prepared for rising global interest rates and possible episodes of financial market turbulence. The report projects a significant deterioration in the fiscal sustainability gap driven by a 1‐standard deviation interest rate increase, particularly for Latin America and the Caribbean (LAC), AFR, and ECA (about ‐1.5%).

# 3.2. Growth of the banking systems, elevated non‐performing loans, and strengthening of capital buffers

Banking system assets and credit across EMDEs have been growing relative to GDP in the last decade ‐‐ particularly larger systems have expanded continuously and reached all‐time highs (Figure 3, A‐D). The median bank assets to GDP ratio stood at 32.5% in 2007 and has increased to 36.5% in 2017 although it has fallen from a peak of 41.6% in 2014. However, importantly, the largest systems (75<sup>th</sup> percentile) have seen continued growth in bank assets which currently stands at an all‐time high of 64.7%, up from 57.5% in 2007. Bank credit to the private sector relative to GDP has exhibit a similar growth pattern. At 34% in 2017, median private credit to GDP is near its highest since 2000. For the larger systems private credit stands at 54.4% of GDP up from 48.9% in 2007.

At the same time, bank capital buffers have continued to strengthen in the last decade (Figure 3, E and F). Non‐performing loans increased since the crisis, remained stable, and only improved in 2017. However, poor performers seem to face debt overhang issues (Figure 4, A and B). Median non‐performing loans (NPLs) as a fraction of total gross loans increased to 5.5% during the crisis and only came down in 2017 to 4.2%. Countries with larger NPL problems (75<sup>th</sup> percentile) have seen a slight improvement since the crisis, but remain relatively high at 10%, suggesting debt overhang problems. Notwithstanding important caveats regarding NPL data integrity and cross‐ country comparability, median regulatory capital to risk‐weighted assets has steadily increased 19
to 17.8% in 2017, well above regulatory minima, suggesting that EMDE banking systems are overall in a better position to withstand shocks. Even the weakest capitalized systems (25<sup>th</sup> percentile) have managed to strengthen their buffers with regulatory capital ratios at 15.1%.

Default risk estimates of publicly‐traded financial institutions ‐‐ including non‐banks ‐‐ have fallen since the crisis and are currently around pre‐crisis levels (Figure 4, C and D). This implies that markets judge financial institutions to be broadly able to withstand shocks, consistent with increasing capital buffers. We use firm‐level estimates of the probability of default (PD) within the next 60 months for 1,786 listed financial institutions in 36 EMDEs (see Box 4). At the height of the global financial crisis, the median country PD reached 4.4% and has fallen since – punctuated by bouts of volatility – and currently is around pre‐crisis levels of 1.1%.<sup>5</sup> However, there is substantial variation across regions. In December 2017, the median PD was the highest in SAR at 2.2% and lowest in LAC at 0.63%.

# 3.3. The sovereign – bank nexus appears to have been increasing in EMDEs

The results presented in this section come with strong caveats since the nexus is inherently difficult to assess. Due to country idiosyncrasies including the role of the government, data lags, and data opacities the results presented in this section should be interpreted with caution. Deeper analysis at the country level is required ‐‐ using more granular data and expert judgement‐‐ to assess the nature, strength, and risks associated with the nexus.

Bank exposures to the sovereign have increased rapidly in EMDEs, both relative to GDP and total banking system assets ‐‐ this suggests that the sovereign – bank nexus is increasing (Figure 4, E and F and Figure 7, A and B). First, the total exposures across the government and non‐financial public entities from the median banking system has more than doubled from 4% to GDP in 2007 to over 8% to GDP.<sup>6</sup> For the countries with elevated exposures (75<sup>th</sup> percentile), the level stands

> 5 The PD is calculated as the cross‐country median of the firm median within each country for each point in time. The methodology underpinning the PD comes with important caveats (see Box 4).

> 6 Total government exposures of banks is defined as the sum of banks’ claims on i) the central government, ii) state government, iii) the local government, and iv) and non‐financial public entities.

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at about 15% of GDP. This is similar to the median levels in the MENA and SAR regions which have the largest sovereign exposures. Second, banking systems appear to have taken on larger balance sheet exposures to sovereign securities. Using a restricted sample of banks that report both sovereign securities and total assets data, the sovereign securities holdings for the median banking system has doubled since 2007, from 5.1% to 10.9% of total assets. For the banking systems with high exposures (75<sup>th</sup> percentile), the holdings represent 16.4% of banking assets. Those numbers are lower than the ones from Dell’Ariccia et al. (2018), and closer to the Gennaioli et al (2014), as our sample covers 1,839 banks from 138 EMDEs.<sup>7</sup> Several EMDEs face a situation of high government debt _and_ elevated bank exposures to the sovereign – this suggests that risks related to the sovereign – nexus may have increased (Figure 5, A and B, Figure 6A). However, the latter could happen because there has been a shift in portfolio composition shares away from high‐capital risk weight exposures (i.e., private borrowers) to capital charge exempt government. As a result, the buffers may appear healthier than they are.

- **_Government debt versus banks’ total government exposure to GDP._** Figure 5A shows the banks’ total claims on central, state, and local government and non‐financial public entities to GDP. This figure suggests that countries with high government debt and high banks’ exposure to the government may face elevate risk.

- **_Government debt versus banks’ government securities to total bank assets._** Figure 5B takes a different perspective on bank exposures: sovereign securities holdings relative to the size of the banks’ balance sheets. Sovereign holdings of 15% or more of the bank balance sheet is quite high and many countries are well above this.

- **_EMBI spreads versus financial institutions’ probability of default._** Figure 6A takes another approach to get a sense of the nexus. Countries with both a high median

> 7 Dell’Ariccia et al (2018) established that the median bank holdings of government bonds is 16.7% of bank total assets in EMDEs, for a sample of 126 banks, between 2005 and 2014. The sample includes only banks that continuously reported information between 1999 and 2014. Gennaioli et al (2014) estimated that median bank holdings of government bonds in 8.11% (8.79%) of total assets for a sample of 3,976 (2,058) banks in 157 (128) Non‐OECD countries (and also reported data for at least 2 consecutive years and other variables such as leverage, profitability, cash and short‐term securities, interbank balances), between 1998 and 2012.

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probability of default (PD) of financial institutions _and_ higher sovereign spreads may more readily be faced with negative feedback loops.

We propose a novel, simple Nexus measurement framework (Box 4). Our Nexus indicator measures the association between sovereign stress (proxied by the EMBI spread) and bank stress (proxied by the median probability of default (PD) of financial institutions in the next 60 months). Using a quantile regression framework, we document that across EMDEs the Nexus indicator is relatively weak at low levels of sovereign stress but increases rapidly when sovereign stress increases – this produces a “Nexus smile”. For example, Figure 7C shows that in periods where EMBI spread is around the 10<sup>th</sup> percentile and the sovereign is not under stress, a one‐percentage point increase of the median financial sector PD is associated with a 20‐basis points increase in the EMBI spread. However, at the 90<sup>th</sup> percentile of the EMBI spread when sovereign stress is high, the same increase in the PD leads to a 120‐basis point increase in the EMBI. We find that the “Nexus smile” is particularly strong for ECA and SAR (Figure 7D).

We also estimate the Nexus indicator over time **.** We use a 24‐month rolling window regression approach to calculate the Nexus distribution across countries for each month. Figure 7E clearly shows that the Nexus peaked at the height of the global financial crisis. At that point, the Nexus indicator stood at 200 basis points. In other words, a 1‐percentage point increase in the financial sector PD was associated with about a 200‐basis points increase in the EMBI spread for the median country. As of December 2017, the Nexus stands at about 120 basis points more than four times higher compared to December 2013. Figure 7F shows that with a median of almost 300 basis points, the Nexus appears particularly high in AFR.

# **Box 4: Measuring the sovereign – bank nexus in EMDEs**

We propose a simple “Strength of Nexus” indicator which captures the association between stress in the financial sector and financial stress in the sovereign sector. A higher value indicates a tighter nexus.

**_Measuring financial sector stress._** We measure financial stress in the financial sector by using the median value of the Probability of Default (PD) in the next 60 months for all listed financial institutions in the country – this also includes non‐banks. The PD is calculated by the National

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University of Singapore‐Credit Research Initiative using a Merton (1974) model with stability adjustments suggested by Duan (2010) and considering macroeconomic and firm‐specific financial factors.<sup>8</sup> We cover monthly data of 1,786 listed financial institutions in 36 EMDEs.

**_Measuring sovereign stress._** We measure financial stress in the sovereign public sector by using the sovereign EMBI spread for 36 EMDEs. We recognize that the sovereign EMBI spread tracks US‐dollar denominated sovereign debt instruments with minimum face value outstanding of US$500 million, but we consider the sovereign EMBI spread to be a reasonable proxy for the risk of sovereign debt instruments in local currency as well.

**_Quantile regressions to estimate nexus strength at increasing levels of sovereign stress._** To calculate the Nexus indicator, we estimate the following basic model:

Sov. EMBI spread�,� �α�β∗Median PD Financial Institutions�,� �γ∗D� �ε�,� (1) where subscripts _c_ and _t_ represent country _c_ and time _t_ , _Dc_ represents a set of country‐fixed effects, and ε�,� is the error term. β is our Nexus indicator with higher values suggesting a tighter nexus. For example, if β�100 , a 1 percentage point increase in the PD, is associated with a 100‐basis points increase in the EMBI spread. We conjecture that the Nexus strengthens at higher levels of sovereign stress. To estimate the Nexus indicator at different levels of sovereign stress, the coefficient β is estimated using quantile regressions which produces an estimated β for each percentile of the EMBI spread. Figure 7, Panel C shows the estimated _β_ s for 10<sup>th</sup> to 90<sup>th</sup> percentiles using an unbalanced panel of monthly information for 36 EMDEs between January 2000 and December 2017. Similarly, Figure 7, Panel D shows the estimated _β_ s for 10<sup>th</sup> to 90<sup>th</sup> percentiles for each World Bank region.<sup>9</sup>

**_Rolling regressions to estimate the nexus strength over time._** To estimate how the Nexus indicator changes over time, we estimated the model in (1) using rolling median regressions <u>for each country (without country fixed effects) using a 24‐month rolling window. Figure 7,</u> Panels E and F show the cross‐country median of the estimated country‐level β s for each month, and by region as of December 2017.

> 8 For more details see The Credit Research Initiative of the National University of Singapore (2018), Merton (1974), and Duan (2010).

> 9 Country coverage: EAP: China, Indonesia, Malaysia, Philippines, Vietnam; ECA: Croatia, Georgia, Kazakhstan, Romania, the Russian Federation, Serbia, Turkey, Ukraine; LAC: Argentina, Belize, Brazil, Chile, Colombia, Jamaica, Mexico, Peru, the República Bolivariana de Venezuela; MENA: the Arab Republic of Egypt, Jordan, Morocco, Oman, Tunisia; SAR: India, Pakistan, Sri Lanka; SSA: Ghana, Kenya, Namibia, Nigeria, South Africa.

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**_<mark>Caveats.</mark>_** <mark>Our proposed Nexus measure only captures an association between financial sector</mark> and sovereign health. It is silent on the direction of causality and does not disentangle potential channels of transmission (including domestic and global channels).

- 3.4. Reverse stress test: Haircuts on sovereign securities to breach minimum bank capital

Severe sovereign distress is often accompanied by haircuts. To gauge banks’ risk exposure to sovereign haircuts, we calculate for each banking system in our sample the required haircut to government securities that breach the 4.5% CET1 capital buffer, assuming other sources of capital are unavailable.<sup>10</sup> This is a strict approach since we assume only the highest quality capital (CET1) is accessible. We calculate this haircut as follows: Haircut� �∑������CET1 ratio�,� �4.5%�∗RWA�,���∑���� Holdings Government Sec�,� (2) where subscripts _c_ and _i_ represent country _c_ and bank _i,_ respectively, and _N_ the total number of banks in country _c_ . _CET1 ratioi,c_ , _RWAI,c_ , and _Holdings Government Seci,c_ are the Common Equity Tier 1 ratio, the Risk Weighted Assets, and the total amount of Holdings of Government Securities reported by bank _i_ in country _c_ . 4.5% is the minimum CET1 ratio required in Basel III.

We find that the most vulnerable banking systems in MENA and SAR would require historically plausible haircuts of less than 20% to erode CET1 capital buffers ‐‐ these banking systems are thus particularly vulnerable to sovereign debt restructurings (Figure 6B). According to IMF (2012), in practice, the range of debt relief as a result from sovereign debt restructurings has varied from an estimated 5% net present value reduction in Dominican Republic (2005) to nearly 90% in Iraq

> 10 Our sample covers 474 commercial banks in 33 EMDEs that reported CET1 ratios, risk‐weighted assets, and holdings of government securities. Information is as of 2016, except for Georgia, Jordan, Eswatini (2015), and Cambodia, Kazakhstan, Kenya, Senegal, Tanzania (2014). The source of the information is Fitch.

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(2006). Cruces and Trebesch (2013) estimate a 37% average haircut for the sample period 1978– 2010 and a 50% average haircut during 1998–2010.

# 3.5. Strong association between financial stress and banks’ total exposure to the public sector

Regression estimates suggest that financial sector and banks’ total exposure to the public sector are strongly associated, even after controlling for global financial conditions (i.e., the VIX index). Spreads on sovereign dollar‐denominated debt appear to price this in (Table 2). To explore this link, we run panel regressions with country‐ and year‐fixed effects (with standard errors clustered at the country level) to explain the median probability of default (PD) of financial institutions within the next 60 months.

- In a sample of 52 EMDEs for months in the period 2000 ‐ 2017, we find a strong association with banks’ total exposure to the public sector to GDP (this includes central, state, and local government and public non‐financial entities). Regressions 1 and 2 suggest that a one percent increase in public exposure raises the PD by 0.16%, even after controlling for the VIX, a widely used proxy for global financial stress and risk appetite. This effect is economically relevant since the sample means for banks’ total claims and the PD are 11.7% and 2.2%, respectively, and both exhibit substantial cross‐country variation.

- In a smaller sample of 36 countries, Regressions 3 and 4 show that the EMBI spread is associated with the PD as well, although the effect diminishes once the VIX is controlled for. This may also in part be explained by the fact that the PDs are estimated from equity prices which themselves depend on global financial conditions.

- Regressions 5, 6, and 7 show that banks’ total exposure is no longer significant in the presence of the EMBI spread and an interaction. This suggests that international investors already price in the effects of bank exposures through the EMBI spread.

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# 4. What are the policy implications?

We offer six considerations for policy makers:

1. **Maintaining fiscal and bank buffers.** A straightforward implication of the discussion above is to improve and maintain sovereign and bank balance sheet strength 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 contingent liabilities. Besides managing sovereign debt stocks and flows, important risk factors that policy makers should manage include the debt composition in terms of currency, floating versus fixed rates, maturities, and the investor base. For banks this suggests maintaining strong and transparent capital and liquidity buffers, particularly if the banking system is relatively large and contains systemic banks. The Basel III capital and liquidity accords aim to make banks safer and many countries, including EMDEs, have been in the process of adopting the framework. In this context, the Financial Stability Board recently found that large, global banks are better capitalized, less leveraged and more liquid (FSB (2018)).

2. **Strengthening surveillance and supervision** . Banking crises are typically preceded by rapid credit growth, supported by a deterioration in underwriting standards, and regulatory forbearance which allows financial risks to grow, potentially in a systemic fashion. To identify and mitigate these risks, strong, risk‐based macro‐ and micro‐ prudential frameworks are required, executed by a well‐equipped agency or agencies. Moreover, diagnostic and monitoring tools such as stress tests, early warning models, and contingent liability analysis can help to identify the unsustainable intensification of the nexus. However, EMDEs often lack strong frameworks and face institutional constraints.

3. **Improving transparency and data quality of bank‐sovereign linkages and contingent liabilities.** This is also critical for surveillance and prudential purposes. Moreover, during times of stress, investors may assume the worst and indiscriminately act with excessive 26
risk aversion which may amplify stress. Thus, transparency of balance sheet linkages between the sovereign and banks is key, yet it is often lacking. For the sovereign, timely information on ownership linkages with state‐owned enterprises and other sources of contingent liabilities may be difficult to obtain. For banks, disclosure requirements on all sovereign exposures should be in place, including how they are classified for accounting purposes. This is particularly relevant in EMDEs since undisclosed forms of government‐ linked borrowing have occurred.

4. **Addressing the sovereign exposures channel.** Considering the various important roles sovereign debt markets play in the economy, domestic sovereign exposures typically enjoy preferential regulatory treatment. As a result, most jurisdictions refrain from imposing risk weights, exposure limits, and haircuts on transactions which use sovereign instruments as collateral. This arrangement naturally encourages banks to hold sovereign exposures, perhaps more than would be optimal. Further, such preferential treatment, natural home bias, and financial repression in some countries, creates captive demand for sovereign debt which may weaken fiscal discipline. Various international reform options are currently debated to address this “excessive exposure” problem including through risk weights, sovereign stress testing, capital charges for concentration risk, and disclosure requirements. However, some of these measures may pose implementation challenges for EMDEs (Box 6). More broadly, diversification of the domestic institutional investor base and capital market development and deepening are important steps to address this channel as it will: provide banks with more investment opportunities, diversify the government bond investor base, and reduce government bond market volatility.

5. **Addressing the government support channel.** This channel is particularly relevant for countries with relatively large, bank‐centric or fast‐growing banking systems.<sup>11</sup> Policy makers need to consider i) ex ante measures to reduce moral hazard and the probability of a crisis and ii) ex post measures to reduce the severity of a crisis and the exposure of

> 11 Promoting capital market development may help ameliorate this channel since it will reduce excessive reliance on bank credit and may prevent excessive growth of the banking system. However, capital market development, particularly for private instruments, is challenging for most EMDEs.

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tax payers to losses. Policy makers can try to reduce explicit guarantees, including through reviewing the role of state‐ownership of banks.<sup>12</sup> They can also address implicit guarantees to domestic systemically important banks which are “too big to fail” (TBTF). Ending the TBTF conundrum and the associated moral hazard problems has been a prime focus of the G20 global financial regulatory reform agenda (e.g., FSB 2010, 2011, 2018). The proposed measures aim to resolve such institutions in an orderly manner, while minimizing losses to taxpayers and maintaining continuity of their vital economic functions. These include: higher and stronger buffers, more intensive supervisory scrutiny, strengthening of core financial market infrastructures to reduce contagion risks, and the formulation of a framework to swiftly and effectively resolve systemically important financial institutions (i.e., the “ _Key Attributes_ ”; Box 7). Collectively, these measures weaken the government support channel, diminish moral hazard problems, and reduce spillovers to the real economy. The Financial Stability Board found that implementation of TBTF reforms is advancing, with reforms progressively taking effect, but results remain uneven. Moreover, some of these policy measures are difficult to implement in EMDEs given the structure of their financial systems and institutional capacity constraints.

6. **Considering policy trade‐offs carefully.** 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 banks’ liquidity management. Further, poorly calibrated risk weights could prove to be pro‐cyclical. Moreover, limits may inhibit banks from acting as a buffer and step in to resolve temporary fiscal stress. Such restrictions may force the government to take stronger pro‐cyclical fiscal measures which may amplify sovereign distress and weaken economic activity. Restrictions on asset holdings may also undermine other objectives including capital market development and the smooth transmission of monetary policy. To weaken the government support

> 12 This may also improve efficiency and competition in the financial system since state‐owned banks typically exhibit weaker performance.

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channel, policy makers may try to adopt explicit measures that rule out any support, such as the refusal to formally establish a resolution backstop, but such action is unlikely to credibly address the time inconsistency problem identified earlier. However, this could lead to contagion that triggers a deeper crisis with larger social losses. As another example, bail‐in measures should be carefully calibrated to avoid that losses are assigned to creditors which are not ready to bear them.

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# **Box 5: Regional perspectives**

<u>Eastern Europe and Central Asia</u><sup>13</sup>

# **Key characteristics and trends in public debt and financial sector exposures**

Albania (80.6% of GDP), Ukraine (71.9% of GDP) and Kyrgyz Republic (60.5% of GDP) had the highest public debt levels in ECA no EU. Bulgaria (78.9% of GDP), Croatia (76.5% of GDP), Romania (49.4% of GDP), and the Czech Republic (45.4% of GDP) had significant shares of foreign currency debt. All four countries are not part of the euro area and the major share of their foreign currency issuances are denominated in euro. A large part of public debt in Armenia (2017), Azerbaijan (2016), Georgia (2018), and Ukraine (2017) is medium‐ to long‐ term maturity and denominated in foreign currency, while in Kazakhstan, public debt appears to be denominated in equal share of both local and foreign currency and in the Russian Federation the majority of the public debt is in local currency denominated.

According to 2016 Fitch data, Albania and Romania had over 20% of bank assets invested in government securities. In addition to the direct exposure, Romanian banks are indirectly exposed to the sovereign via their mortgage loan portfolio, as the majority of these loans are under the _Prima Casa_ program, where the states guarantees half of the mortgage. From 2012 to 2016 the share of sovereign debt in total bank assets increased by more than 10 percentage points in Ukraine and Serbia. This is partly explained by the financial crisis experienced in both countries, resulting in bank recapitalization with government bonds and greater investments in government assets as a risk mitigation technique given widespread non‐performing loan problems.

Some banking sectors also face substantial exposure to sovereign risks through state‐owned enterprises (SOEs). Turkmenistan and Uzbekistan are particularly exposed reflecting the economic structure with loans to SOEs accounting for over 50% and 40% respectively of total banking sector assets. However, banks are not the only institutions exposed to sovereign risks. The Unified Pension Fund in Kazakhstan invests 50% of assets in government papers and about 13% in SOEs. Following the 2017 exchange rate liberalization and currency devaluation in Uzbekistan, SOEs with foreign exchange denominated loans or with high import dependence experienced trouble servicing their debts and required government funds and debt restructuring. Banks received regulatory forbearance to avoid having to constitute provisions on those loans.

# **Concerns about financial sector exposure to sovereign risk and vice versa**

Large exposures to the sovereign and broader public sector in countries with weak fiscal positions may affect bank capitalization and credit growth, with a subsequent negative impact in the economy. In countries in which state‐owned banks (SOBs) dominate the banking sector, difficulties by the public sector to serve their debt would affect capitalization of SOBs, which 30
in turn may further increase public debt (to fund the recapitalization of the SOBs), and/or exacerbate the credit crunch and economic slowdown given shareholder difficulties to raise capital at the time of bank distress. In some countries, failure of private sector banks forced the public sector to take over weak banks, drastically increasing the share of SOBs in total banking sector assets.

It is difficult to assess the true fiscal position of some countries due to opacity of the fiscal position and/or uncertainty about contingent liabilities of the large public sector which may hamper access to markets in times of need. Proliferation of public‐private partnerships (PPPs) and guarantees for infrastructure financing further complicate the fiscal analysis. As the credit and the economy decelerate, the performance of SOEs, SOBs and the fiscal position of the sovereign deteriorate, further resulting in a vicious circle.

In some countries, banks reliance on public sector funding, due to concentration of Treasury or public sector resources, exposes banks to liquidity risks at time of sovereign distress, which could further exacerbate a credit crunch.

Financial sector exposure to sovereign related risks is problematic in many countries not because of the sovereign credit risk, but because the exposures are remunerated at below market rates, causing stress in the profitability and or solvency of financial institutions. This in turn can create fiscal contingent liabilities. Provision of subsidized lending by public banks in some countries compresses lending margins and banks internal capital generation, forcing the sovereign to inject capital to sustain credit growth.

Finally, vulnerabilities in the banking system can also affect public debt levels. Exposure to politically connected firms, related‐party lending and weak oversight in some countries resulted in a banking crisis and bail outs of SOBs that have substantially increased public sector debt.

<u>East Asia and Pacific</u><sup>14</sup>

**Key characteristics and trends in public debt and financial sector exposures**

In many East Asian countries, there are implicit government guarantees to the banking sector and there is an expectation that should a major banking crisis arise, the government will intervene to contain the losses and spillover effects for the whole financial system and the economy overall. Public debt remains moderate and/or manageable in EAP’s largest economies, but efforts will be needed to rebuild fiscal buffers. In terms of the evolution of

> 13 This regional section is based on substantive inputs provided by Eva Gutierrez, Raquel Letelier, and Alena Kantarovich (FCI‐ECA), and Elisa Gamberoni (MTI‐ECA).

> 14 This regional section is based on substantive inputs provided by Ana Maria Aviles (FCI‐EAP), and Richard Record (MTI‐EAP).

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general government debt as a percentage of GDP in the next couple of years, most EAP countries appear to be on a stable or downward trend. Indeed, China and Indonesia are on track to keep their levels of general government debt below 40%, respectively 30%, the Philippines at around 40%, Thailand below 50% and Malaysia and Vietnam below 60% of GDP.

The assessment of public debt in China is typically based on two definitions of debt, the main difference between them being the coverage of local government debt. Depending on which definition of government debt is used, China’s public debt in 2016 is between 37% under the ‘narrow’ definition and 62% under the ‘augmented’ definition. Various factors such as a high savings rate, strong external position, capital controls, limited alternative domestic assets suggest that this level is manageable. However, contingent liabilities from the financial sector may be significant.

The other large EAP economies are also experiencing manageable levels of public debt, but fiscal space in many of them is shrinking as they are implementing accommodative fiscal measures to support growth.

In terms of the composition of public debt, in EAP’s largest economies, most of it is medium‐ to‐long‐term debt. Moreover, in China, Malaysia and Thailand public debt is overwhelmingly denominated in local currency, whereas in Indonesia, Philippines and Vietnam, foreign currency‐denominated debt takes a higher share (although still below 50% of all public debt).

# **Concerns about financial sector exposure to sovereign risk and vice versa**

Overall, financial sector exposure to sovereign risk is largely indirect, via contingent liabilities for the public sector. The region’s financial sector is heavily dominated by the banking sector, whose overall vulnerability remains relatively moderate to low. The resiliency of the region’s banking system is underpinned by strong capital buffers and asset quality.

Private sector debt is considered as one of the key sources of financial stability risks in the EAP region. With the long period of low interest rates in the U.S. and subsequently in Asia, most economies in the region have seen significant growth in private sector debt over the past decade.

After a period of rapid credit growth in many of the large economies in the region, bank credit growth as a share of GDP has moderated since 2015, partly as the result of a concerted effort to deleverage and improve regulatory standards. However, the overall level of bank credit remains relatively high, including in China, Malaysia, Thailand and Vietnam. Conversely, in some other countries in the region, such as in Cambodia and the Philippines, bank credit growth continues at a relatively faster rate from a lower base, increasing by 19.4% and 17.7%, respectively, between 2017Q3 and 2018Q2. In other countries such as in Indonesia, however, the level and growth rate of bank credit have remained relatively low.

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<mark>Vulnerabilities exist in the commercial sector, with China being the most exposed to the</mark> corporate sector, and Malaysia and Thailand the most exposed to households. Because of many years of credit growth driven by the corporate sector, China continues to have a large debt overhang, much of which is in the hands of weak corporates and local government entities, as well as non‐bank financial institutions (NBFIs). Credit growth vastly exceeded GDP growth. Since 2016, China has begun a slow and gradual deleveraging process, but the pace of progress may slow as trade tensions escalate and concerns over domestic growth become more evident.

In Malaysia, the household sector accounts for more than half of the total banking system loans (57% as of April 2018) and household debt remains high at 84.6% of GDP in 2017Q3. In Thailand, most of its private sector credit is household debt, which represented 78% of GDP at the end of 2017. Rising unemployment or higher interest rates could lead to difficult conditions for small businesses and some households to pay their obligations. There are also some asset‐ quality issues related to SMEs with weak economic performance and to unsecured retail loans.

# **Policy implications**

Countries such as China, Malaysia and Thailand, have already taken significant steps to reduce private sector leverage. For instance, in China, as early as 2016, the government has been adopting various measures to reduce leverage in the shadow‐banking sector. Such policy measures target investment operations of commercial bank wealth management products (2013), inter‐bank (inter‐financial institutions) activity (2014), transfer of credit beneficiary rights (2016), risk control of banking sector, targeted measures focusing on arbitrage (2017).

# <u>South Asia</u><sup>15</sup>

# **Key characteristics and trends in public debt and financial sector exposures**

The three largest economies in the region – India, Pakistan, and Bangladesh – have varying public debt profiles. In 2018, Bangladesh, with the total public debt of 31.2% of GDP, had the lowest level among the three, compared to Pakistan’s 73.4% and India’s 70.2%. These sovereign debt levels are within manageable limits. Debt service payments are around 20% of total fiscal expenditures in India and Pakistan and 11.1% in Bangladesh, against relatively modest budget revenues.

The debt sources and trends have remained largely stable during the past few years. Neither of these countries have taken significant advantage of tapping international markets during the recent period of sustained low rates and funding availability, although Pakistan did issue

> 15 This regional section is based on substantive inputs provided by Marius Vismantas (FCI‐SAR), and Muhammad Waheed (MTI‐SAR).

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external sovereign bonds and sukuks and took out commercial loans. Indian government traditionally does not borrow on international markets. Bangladesh has not issued sovereign bonds neither externally nor domestically and relies largely on bilateral and multilateral borrowing as well as tapping retail savings of the population through the National Savings Scheme (NSS). India has issued substantial amounts of domestic bonds, largely held by domestic banks (around 54% of the total, including holdings by the central bank) and institutional investors (around 30% of the total). Pakistan has relied significantly on local bonds and loans – with local banks providing the bulk of funding in both streams. A Pakistani version of the NSS also brings considerable borrowed resources to the budget.

The strongest impact of the financial sector‐sovereign nexus on domestic economic activity is manifested through financial repression, usage of state‐owned banks for policy purposes, and a strong private sector crowding‐out effect due to the government’s strong appetite for domestic resources. Through its the Priority Sector Lending (PSL) program, India mandates all public and private commercial banks, urban cooperative banks, and local area banks to direct 40% of their loans to segments deemed to be of economic and social priority (the target goes to 75% for regional rural banks and small finance banks). Central banks of Bangladesh and Pakistan do not impose directed lending formally, but encourage banks towards sectors of social and economic priority of their respective countries through so‐called indicative targets (e.g., for agriculture and SME lending in Pakistan). Bangladesh government recently has attempted to set ceilings on bank lending and deposit rates.

# **Concerns about financial sector exposure to sovereign risk and vice versa**

While all countries have contingent liabilities related to SOEs, there have been no recent instances of payment arrears on sovereign obligations. Distress through domestic sovereign exposures held by local banks and non‐bank institutional investors in Bangladesh, India and Pakistan is unlikely, with countries’ central banks expected to provide liquidity support.

Pakistan’s banking system has the largest exposure among the three countries to sovereign debt. Through lending to the government and purchasing its debt securities, as well as lending to sub‐national governments and state‐owned enterprises, the Pakistani banks accumulated over 60% of their total exposure to the public sector as of 2017, leaving little space for lending to the private sector. Exposures of the banks in Bangladesh and India are much lower than the levels in Pakistan, at 16% and 27.5%, respectively. All domestic debts are in local currencies, with India and Pakistan having issues along the yield curve with maturities up to 30 and 20 years, respectively, with only a small share of borrowing at the long end. Varying sovereign exposures result in different levels of crowding‐out effects for the private sector borrowing: banks in Bangladesh and India had claims on the private sector of around 85% and around 66% of the total claims in 2018, respectively, whereas Pakistan’s banks only had 33%. Notably, the trend in Pakistan of the past couple of years has turned towards increasing levels of lending to the private sector.

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Bangladesh and especially India have substantial presence of state‐owned banks. India also has large state‐owned non‐banks, insurance companies, such as LIC and GIC, and provident funds, which serve as significant investors into domestic sovereign debt. For example, in 2017 India’s banks (including the central bank), insurance companies, and provident funds together held around 85% of the total marketable securities issued by the government. Pakistan’s banks are mostly private owned and are not captive investors. However, the appetite of the successive Pakistani governments for increased borrowing made it an easy proposition for the banks to grow their sovereign exposures which require little effort in terms of risk underwriting compared to private sector lending (due to zero risk weights of sovereign exposures) and offered attractive yields leading to stable profitability of banks. Pakistan’s non‐bank sector, including institutional investors, has also kept high sovereign exposures.

Non‐performing loans (NPLs) pose challenges to financial stability and economic growth in India and Bangladesh. India has acted to put resolution mechanisms in place and has recapitalized its banks, at a considerable expense to taxpayers. In Bangladesh state‐owned banks hold more than half of the NPL stock and remain undercapitalized despite public capital injections of more than $1.2 billion over the past 7 years. Bangladesh has recently increased regulatory forbearance and eased loan classification standards, thus reversing progress made in adopting international regulations. Banks remain well capitalized in Pakistan yet carry a high concentration risk due to their large sovereign exposure; replacement of these with private sector exposures, or higher risk weights for exposures to sovereigns based on global rather than local risk ratings, as is being proposed under the emerging Basel IV framework, would significantly increase the banks’ capital needs.

<u>Middle East and North Africa</u><sup>16</sup>

# **Key characteristics and trends in public debt and financial sector exposures**

Among the oil‐based economies only Bahrain (90.6%) and Qatar (54.4%) breach the 50% public debt to GDP levels with Saudi Arabia (17.2%), United Arab Emirates (20.7%) and Kuwait (27.1%) with comfortable debt levels. The non‐oil based countries are characterized by relatively elevated levels of public debt to GDP with Lebanon (149%), Egypt (101.2%) and Jordan (95.6%) followed by Tunisia (69.2%) and Morocco (63%).

Bahrain’s higher debt profile is molded by a very high reliance on limited oil revenues that are insufficient to finance recurring subsidies and social schemes with the government finding it challenging to implement much needed economic reforms. The absence of reforms and continuing hemorrhaging of resources has led to ratings downgrade of Bahrain to non‐ investment grade in 2016, thereby further constraining access and increasing borrowing costs.

> 16 This regional section is based on substantive inputs provided by Syed Mehdi Hassan (FCI‐MENA), and Emmanuel Pinto Moreira (MTI‐MENA).

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Qatar has had to resort to a combination of domestic and external financing to finance the fiscal deficit which has been heightened by the ongoing rift with some of its neighbors. Public debt (estimated at 54.4% of GDP as at end‐2017) remains sustainable, given the size of Qatar’s sovereign wealth fund (SWF) with foreign reserves covering 709.7% of external debt and minimal debt servicing at 3.4% of revenues.

Lebanon has one of the highest levels of government debt to GDP (149%). The country has been serving as a financial center for the Middle East primarily catering to its large diaspora of non‐resident citizens spread globally, who have been sending significant amounts of remittances and placing sizeable foreign currency deposits. The banking sector as a result is among the largest in Emerging Markets in terms of assets at 397% of 2016 GDP.

# **Concerns about financial sector exposure to sovereign risk and vice versa**

Lebanon is now more reliant on the continuing deposit of foreign currency by expatriate Lebanese and the Central Bank has been offering ever higher returns to commercial banks. To boost its foreign currency reserves and defend the peg, the Central Bank has entered financial swaps with commercial banks. This is in addition to repatriation of US$1.9 billion of foreign assets by commercial banks that were also invested in Lebanese Eurobonds and Central Bank CD’s. These combined transactions have exponentially increased the already large exposure of commercial banks to the sovereign. The levels of sovereign exposure in the books of Lebanese banks expose them to any further impairment/downgrade in the sovereign credit ratings and further restrict their ability to liquidate their holding in the absence of a secondary market and buyers. The banks are also at risk of strained US$ liquidity and financial sustainability in the event of any geopolitical and or macro‐economic event with resultant demands from customers to withdraw deposits and may pose an inherent financial stability risk.

# **Policy implications**

The countries in MENA are in varying stages of implementing Basel II and Basel III accords. In keeping with the rest of the world, the countries in the region extend more favorable prudential and supervisory treatment to their banking sector’s exposures to the sovereign as compared to other asset classes. Countries have opted to exercise their national discretion (as do all members of Basel Committee) in applying zero risk weights to the sovereign risk exposures denominated in local currency and waiving large exposure and or single obligor limits with no limits and or haircuts applied to domestic sovereign exposures eligible for inclusion as high‐quality liquid assets in meeting liquidity requirements in the Basel framework.

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# **Box 6: Addressing the sovereign exposures channel – Regulatory treatment of sovereign exposures**

# **Existing regulatory approach**

The existing framework applies a favorable treatment for sovereign exposures. Regarding _credit risk_ , it includes a national discretion for preferential risk weight ‐‐ typically set at 0% ‐‐ for sovereign exposures denominated and funded in domestic currency. National discretion is also available to apply a zero haircut for repo‐style sovereign transactions with core market participants. Banks’ exposures to sovereigns and central banks are also exempted under the _large exposures_ framework. Similarly, there is national discretion to apply a preferential default charge regarding _market risk_ . In terms of _liquidity standards_ , there are no limits or haircuts on amount of domestic sovereign debt that are eligible as high‐quality liquid assets. However, sovereign exposures are included in the Basel III _leverage ratio_ framework.

# **Considerations in the December 2017 Basel Discussion Paper**

In December 2017, the Basel Committee on Banking Supervision issued a Discussion Paper to review the regulatory treatment of sovereign exposures and to explore policy options to address concerns arising from the sovereign‐bank nexus (BCBS, 2017). Basel’s ideas are consistent with objectives of the finalized Basel III standards to reduce excessive variability or risk‐weighted assets and facilitate the comparability of banks’ capital ratios. They can be grouped into three categories to address all three of the pillars of the Basel capital framework (see Figure B5.1.): definition of sovereign entities; revisions to the risk‐weighted framework; mitigating concentration risk; revisions to the credit mitigation framework; additional Pillar 2 guidance and Pillar 3 disclosures.

# **Implications for EMDEs**

The Discussion Paper could have significant, possibly unintended, implications for EMDEs regarding banks’ direct exposures to the sovereign, capital market liquidity and development, foreign participation in local markets, and sovereign funding costs. This is largely due to the specific features of sovereign exposures in EMDEs, the role that these play in their real economies, and the stage of economic and financial development, including a lack of deep markets and a diverse institutional investor base. Home‐host<sup>17</sup> differences arising from regulatory treatment of sovereign exposures to EMDEs will also have implications. For example, removing the local currency distinction or withdrawing the Home discretion to accept Host treatment or Home not exercising the discretion can impede EMDE sovereign borrowing. Similar considerations exist if public sector entities are excluded. Also, Home subjecting other Host exposures to the Host sovereign floor can un‐level the playing field for foreign banks and reduce their appetite for holding and making markets in EMDE sovereign debt.

> 17 The Basel framework has different prudential treatments under both the standardized and Internal Ratings‐Based (IRB) approaches for sovereign exposures applied at the subsidiary and consolidated level of all internationally active banks.

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# **Figure B5.1.: Basel Committee’s Potential Ideas on Regulatory Treatment of Sovereign Exposures**

Pillar 1 Pillar 2 Pillar 3

- •Revisions to risk‐weighted framework

- _Removal of internal ratings‐ based (IRB) approach_

- _Positive standardised risk weights_

- Disclosures of sovereign exposures and risk weighted assets by:

- •Guidance on monitoring sovereign risk

- •Stress testing for sovereign risk

- _Jurisdiction_

- •Supervisory responses to  mitigating sovereign risks • _Currency denomination_

- _Accounting classification_

- •Marginal risk‐weight add‐ons for country concentration

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# **Box 7: Addressing the government support channel – The Key Attributes**

# **Context**

In November 2011, The FSB issued the _Key Attributes of Effective Resolution Regimes for Financial Institutions (‘Key Attributes’, ‘KAs’)_ as part of the package of policy measures to address the moral hazard risks and taxpayer loses posed by systemically important financial institutions (SIFIs) (FSB, 2011).

The _Key Attributes_ (endorsed by the G20 leaders) set out the core elements of effective resolution regimes that apply to any financial institution (most importantly banks) that could be systemically significant or critical in the event of a failure. The _Key Attributes_ are a non‐ binding set of principles that form the new international standard for jurisdictions when strengthening their resolution regimes for banks.

Many countries are implementing the _Key Attributes_ in their jurisdictions or are in the process of doing so. Although targeted at systemically important banks (SIBs), the _Key Attributes_ also provide useful guidance for the resolution of many types of non‐SIBs.

# **Some challenges in EMDEs to implement the Key Attributes**

**_Scope._** It is challenging in most EMDEs to determine i) which banks are systemically important to which all _KAs_ should apply and ii) which banks are non‐systemic for which only some of the _KAs_ apply. Complex group structures in some EMDEs may exacerbate these issues.

**_Resolution authority._** In EMDEs it often makes sense to house the resolution authority in the central bank/supervisor. This requires adequate firewalls and governance arrangements to manage any conflicts of interests, what might be a challenge in some EMDEs.

**_Bail in._** During bank resolution, the “bail in” tool wipes out senior claims on the bank **.** However, in many EMDEs, the liability side of the balance sheet of banks consists mainly of small depositors. Bailing in those depositors would only enlarge a financial crisis by eroding the trust in the financial system. Also, the financial markets of these countries are not sufficiently developed for banks to issue “bail‐in‐able” debt securities.

**_Legal safeguards._** In many EMDEs a clear ‘hierarchy of claims’ is missing preventing a quick resolution process and creating uncertainty among shareholders and unsecured creditors. The ‘no creditors worse off as in liquidation principle’ has to be established in most EMDEs. Courts are in many EMDEs a key player in insolvency and resolution procedures. Limitation of the role of the courts, as the _KAs_ require, often runs into constitutional obstacles and legal traditions.

**_Funding._** In many EMDEs, deposit insurance funds are non‐existing, or poorly funded, and in most cases not allowed to contribute to the funding of resolution. Fiscal backstops to finance ‘funding <u>gaps’ in resolution are mostly missing. Financial markets are often shallow and</u>

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financial instruments (issuance of equity, securities, etc.) to contribute to the funding of resolution tools (e.g. bail‐in) are lacking.

**_Access to data and information sharing._** Sound and adequate data systems as well as compliance and accounting standards are a prerequisite for implementing effective resolution regimes. However, these are often weak in many EMDEs. Moreover, there is a need to strengthen the exchange of information between all domestic safety‐net players regarding resolution. Data reliability issues hamper efforts to undertake recovery and resolvability assessments of banks.

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**Table 1: Sovereign and Banking Episodes in EMDEs, 1970‐2017**

||Number of Total<br>Crises<br>(sovereign or<br>banking)|Number of<br>banking crises<br>followed by<br>sovereing crises<br>in a 3‐year<br>period|Number of<br>sovereign crises<br>followed by<br>banking crises in<br>a 3‐year period|Number of bank<br>and sovereign<br>crises starting<br>simultaneously|Number of bank<br>only crises|Number of<br>sovereign<br>only crises|
|---|---|---|---|---|---|---|
|EAP|12|1|0|1|7|2|
|ECA|41|1|0|2|28|8|
|LAC|61|5|0|4|22|26|
|MENA|12|1|0|1|6|3|
|SAR|4|0|0|0|4|0|
|AFR|66|1|2|2|38|21|
|**Total**<br>Source:<br>Note: In<br>column,|**196**<br>Laeven and Valencia<br>second column, eac<br>sovereign and bank|**9**<br>(2018). Own calc<br>h crisis (sovereig<br>ing crises starting|**2**<br>ulations.<br>n or banking) is co<br>simultaneously ar|**10**<br>unted as a single c<br>e counted as one|**105**<br>risis episode. In th<br>crisis episode.|**60**<br>e fifth|

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# **Figure 2: Fiscal Sector Developments in EMDEs**

- A. General government debt (% GDP) 2000‐17

- B. General government debt (% GDP) 2017

<!-- Start of picture text --> 120 120<br>25 pctl 25 pctl<br>median median<br>100 100<br>75 pctl 75 pctl<br>80 80<br>60<br>60<br>40<br>40<br>20<br>20<br>0<br>0<br>AFR EAP ECA LAC MNA SAR<br>C. Fiscal balance (% GDP) 2000‐2017 D. Fiscal balance (% GDP) 2017 regions<br>4.0 2.0<br>25 pctl<br>3.0<br>median<br>2.0 0.0<br>75 pctl<br>1.0<br>‐2.0<br>0.0<br>‐1.0<br>‐4.0<br>‐2.0<br>‐3.0<br>‐6.0<br>‐4.0<br>25 pctl<br>‐5.0 ‐8.0 median<br>‐6.0 75 pctl<br>‐7.0 ‐10.0<br>2000 2002 2004 2006 2008 2010 2012 2014 2016 AFR EAP ECA LAC MNA SAR<br>E. EMBI spreads (bps) 2000‐2017 F. EMBI spreads (bps) 2017 regions<br>1000 600<br>25 pctl 25 pctl<br>900<br>median median<br>800 500 75 pctl<br>75 pctl<br>700<br>400<br>600<br>500<br>300<br>400<br>300 200<br>200<br>100 100<br>0<br>0<br>AFR EAP ECA LAC MNA SAR<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br><!-- End of picture text --> Note: pctl means percentile. Sources: Central government debt and Fiscal balance, World Economic Outlook, IMF; EMBI spreads, Bloomberg.

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# **Figure 3: Banking Sector Developments in EMDEs**

- A. Bank assets (% GDP) 2000‐2016

<!-- Start of picture text --> 70<br>25 pctl<br>median<br>60<br>75 pctl<br>50<br>40<br>30<br>20<br>10<br>0<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016<br><!-- End of picture text -->

- C. Private credit (% GDP) 2000‐2017

<!-- Start of picture text --> 60 25 pctl<br>median<br>50<br>75 pctl<br>40<br>30<br>20<br>10<br>0<br>E. Regulatory capital (% Risk weighted assets)<br>2000‐2017<br>22<br>20<br>18<br>16<br>14<br>25 pctl<br>12 median<br>75 pctl<br>10<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br><!-- End of picture text -->

- B. Bank assets (% GDP) 2016 regions

<!-- Start of picture text --> 100<br>25 pctl<br>90<br>median<br>80 75 pctl<br>70<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>AFR EAP ECA LAC MNA SAR<br><!-- End of picture text -->

- D. Private credit (% GDP) 2017 regions

<!-- Start of picture text --> 100<br>25 pctl<br>90<br>median<br>80 75 pctl<br>70<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>AFR EAP ECA LAC MNA SAR<br><!-- End of picture text -->

- F. Regulatory capital capital (% Risk weighted assets) 2017 regions

<!-- Start of picture text --> 35<br>25 pctl<br>30 median<br>75 pctl<br>25<br>20<br>15<br>10<br>5<br>0<br>AFR EAP ECA LAC MNA SAR<br><!-- End of picture text --> Note: pctl means percentile. Sources: Bank assets, Fitch Connect; Private credit, World Development Indicators, WB; Regulatory capital / Risk weighted assets, Financial Soundness Indicators IMF.

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# **Figure 4: Banking sector risks in EMDEs**

- A. NPLs (% Total gross loans) 2000‐2017

<!-- Start of picture text --> 25 25 pctl<br>median<br>20<br>75 pctl<br>15<br>10<br>5<br>0<br>C. Probability of default of financial institutions (%)<br>2000 2017<br>8<br>25 pctl<br>7 median<br>6 75 pctl<br>5<br>4<br>3<br>2<br>1<br>0<br>E. Banks’ claims on total government and public<br>non‐financial entities (% of GDP) 2000‐2017<br>16 25 pctl<br>14 median<br>12 75 pctl<br>10<br>8<br>6<br>4<br>2<br>0<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br>2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017<br><!-- End of picture text -->

- B. NPLs (% Total gross loans) 2017 regions

<!-- Start of picture text --> 18<br>25 pctl<br>16 median<br>14 75 pctl<br>12<br>10<br>8<br>6<br>4<br>2<br>0<br>AFR EAP ECA LAC MNA SAR<br><!-- End of picture text -->

- D. Probability of default of financial institutions (%) 2017 regions

<!-- Start of picture text --> 3.5 25 pctl<br>median<br>3<br>75 pctl<br>2.5<br>2<br>1.5<br>1<br>0.5<br>0<br>AFR EAP ECA LAC MENA SAR<br><!-- End of picture text -->

- F. Banks’ claims on total government and public non‐financial entities (% of GDP) 2017

<!-- Start of picture text --> 40<br>25 pctl<br>35 median<br>75 pctl<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>AFR EAP ECA LAC MNA SAR<br><!-- End of picture text --> Note: pctl means percentile. Sources: NPLs / Total Loans, FSI IMF; Probability of default, National University of Singapore – Credit Research Initiative; Bank sovereign exposure / Bank assets Fitch Connect; Claims data IFS IMF.

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**Figure 5: Government debt and sovereign bank exposures in EMDEs**

A.Government debt (% GDP) 2017 vs. Banks’ exposures to the sovereign in EMDEs (% GDP) 2016 <!-- Start of picture text --> 160<br>140<br>120<br>100<br>80<br>60<br>40<br>20<br>0<br>0 10 20 30 40 50 60 70<br>Banks' exposures to the sovereign (% GDP)<br>General government gross debt (% GDP)<br><!-- End of picture text -->

- B. Government debt (% GDP) 2017 vs. Holdings of government securities by banks (% Total assets) 2016

<!-- Start of picture text --> 160<br>140<br>120<br>100<br>80<br>60<br>40<br>20<br>0<br>0 5 10 15 20 25 30 35 40 45 50<br>Holdings of government securities by banks (% assets)<br>General government gross debt (% GDP)<br><!-- End of picture text --> Sources: International Financial Statistics, IMF; Fitch Connect. Own calculations.

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**Figure 6: Banks’ risks and sovereign stress in EMDEs**

<!-- Start of picture text --> A. Sovereign EMBI spreads annual median 2017 (bps) vs. Probability of default of financial institutions (%)<br>2017<br>600<br>500<br>400<br>300<br>200<br>100<br>0<br>0 0.5 1 1.5 2 2.5 3 3.5 4<br>Probability of default of financial institutions (%)<br>Sovereign EMBI spreads annual median (bps)<br><!-- End of picture text --> Sources: University of Singapore – Credit Research Initiative; Bloomberg, Fitch Connect. Own calculations.

- B. Haircut in Government Securities to wipe out Common Equity Tier 1 capital (% holdings of Government securities), by region 2016

<!-- Start of picture text --> Haircut (% Holding Gov. 25 pctl median<br>Sec)<br>75 pctl<br>100<br>90<br>80<br>70<br>60<br>50<br>40<br>30<br>20<br>10<br>0<br>AFR EAP ECA MNA SAR<br><!-- End of picture text --> Data as of 2016, except for Georgia, Jordan, Eswatini (2015), and Cambodia, Kazakhstan, Kenya, Senegal, Tanzania (2014). Sample coverage: 474 commercial banks in 33 EMDEs. Source: Fitch Connect. Own calculations.

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<!-- Start of picture text --> n ! [<br>al i} “LA ' a<br>yetyt "N Wen,¢ A a!)‘ ye =<br>t ryhe 1 vayva !wed ' a!ar ",re<br>ay ry “S 1 BN \jfe oy .<br>trw 1 ial] 4 i is Ve<br>yw!‘ 1! \ant rae enon| vw<br>vas , ey i aw an yo i<br>In, ot al Yay’ 'y ‘ 1 i! wary un i |<br>, ras 1 \ Ve, bd ry | il |<br><!-- End of picture text -->
# **Table 2: Financial Institution Probability of Default and Exposure to the Sovereign in EMDEs**

|Dependent variable: Median Probability|of Default Fin|ancial Instituti|ons in 60 mo|nths (monthly|data at count|ry level)||
|---|---|---|---|---|---|---|---|
|VARIABLES|(1)|(2)|(3)|(4)|(5)|(6)|(7)|
|Claims on Total Gov. and PNFEs (% GDP)|0.161***|0.161***|||0.0718|0.0817|‐0.0233|
||(0.0439)|(0.0440)|||(0.0533)|(0.0511)|(0.164)|
|Sovereign EMBI spread (bps)|||0.125**|0.0989*|0.124**|0.0951|0.0854|
||||(0.0556)|(0.0560)|(0.0590)|(0.0589)|(0.0915)|
|Claims on Tot. Gov.*Sov.EMBI spread|||||||0.0161<br>(0.0284)|
|US VIX Index||0.264***||0.228***||0.231***||
|||(0.0214)||(0.0368)||(0.0383)||
|Constant|0.410***|‐0.224|0.151|‐0.251|‐0.00133|‐0.421|0.225|
||(0.120)|(0.135)|(0.302)|(0.245)|(0.314)|(0.264)|(0.502)|
|Observations|7,812|7,812|5,398|5,398|5,295|5,295|5,295|
|Countries|52|52|36|36|35|35|35|
|R‐squared|0.680|0.693|0.710|0.719|0.714|0.723|0.714|
|All variables in logs. "Sovereign EMBI spre<br>Total Government includes central and lo<br>Monthly data January 2000 to December<br>Robust standard errors in parentheses. *|ad" is the m<br>cal governme<br>2017. Countr<br>** p<0.01, **|aximum value<br>nts. PNFEs: pu<br>y and year fixe<br>p<0.05, * p<0|of Sovereign<br>blic non‐fina<br>d effects incl<br>.1|EMBI spread o<br>ncial entities.<br>uded.|bserved in eac|h month.||
|Source: National University of Singapore‐|Credit Resear|ch Initiative, I|MF‐Internatio|nal Financial S|tatistics, Bloo|mberg.||

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