The impact of sovereign credit risk on bank funding conditions

Panetta, Fabio and Correa, Ricardo and Davies, Michael and Di Cesare, Antonio and Marques, José-Manuel and Nadal de Simone, Francisco and Signoretti, Federico and Vespro, Cristina and Vildo, Siret and Wieland, Martin and Zaghini, Andrea (2011): The impact of sovereign credit risk on bank funding conditions.

Abstract

The financial crisis and the ensuing recession have caused a sharp deterioration in public finances across advanced economies, raising investor concerns about sovereign risk. The concerns have so far mainly affected the euro area, where some countries have seen their credit ratings downgraded during 2009−11 and their funding costs rise sharply. Other countries have also been affected, but to a much lesser extent. Greater sovereign risk is already having adverse effects on banks and financial markets. Looking forward, sovereign risk concerns may affect a broad range of countries. In advanced economies, government debt levels are expected to rise over coming years, due to high fiscal deficits and rising pension and health care costs. In emerging economies, vulnerability to external shocks and political instability may have periodic adverse effects on sovereign risk. Overall, risk premia on government debt will likely be higher and more volatile than in the past. In some countries, sovereign debt has already lost its risk-free status; in others, it may do so in the future. The challenge for authorities is to minimise the negative consequences for bank funding and the flow-on effects on the real economy. This report outlines the impact of sovereign risk concerns on the cost and availability of bank funding over recent years. It then describes the channels through which sovereign risk affects bank funding. The last section summarises the main conclusions and discusses some implications for banks and the official sector. Two caveats are necessary before discussing the main findings. First, the analysis focuses on causality going from sovereigns to banks, as is already the case in some countries, and, looking forward, is a possible scenario for other economies. But causality may clearly also go from banks to sovereigns. However, even in this second case, sovereign risk eventually acquires its own dynamics and compounds the problems of the banking sector. Second, the report examines the link between sovereign risk and bank funding in general terms, based on recent experience and research. It does not assess actual sovereign risk and its impact on bank stability in individual countries at the present juncture.

• Item Type: MPRA Paper
• Language: English
• Keywords: Sovereign debt; banks; financial turmoil
• Subjects: G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

Alessandri, P and A G Haldane (2009): “Banking on the State”, Bank of England, mimeo, November, mimeo.

Angelini, P, A Nobili and C Picillo (2009): “The interbank market after August 2007: what has changed, and why?”, Journal of Money, Credit and Banking, October.

Aretzky, R, B Candelon and A Sy (2011): “Sovereign rating news and financial market spillovers: evidence from the European debt crisis”, IMF Working Papers, no 11/68, March

Baglioni, A and U Cherubini (2010): “Marking to market government guarantees to financial systems: an empirical analysis of Europe”, unpublished paper, November.

Baker, D and T McArthur (2009): “The value of the ‘too big to fail’ big bank subsidy”, CEPR Issue Briefs, September.

Bank for International Settlements (1999): 69th Annual Report, June. ——— (2002): 72nd Annual Report, June. ——— (2010a): 80th Annual Report, June. ——— (2010b): BIS Quarterly Review, December.

Bank of England (2010): Financial Stability Report, June.

Bank of Italy (2010): Financial Stability Report, December.

Barajas, A, E Basco, V Hugo Juan-Ramon and C Quarracino (2007), “Banks Turing the Argentine crisis: were they all hurt equally? Did they all behave equally?”, IMF Staff Papers, vol 54, no 4.

Basel Committee on Banking Supervision (2006): “International convergence of capital measurement and capital standards: a revised framework − comprehensive version”, Basel, June.

Bolton, P and O Jeanne (2011): “Sovereign default risk and bank fragility in financially integrated economies”, NBER Working Papers, no 16899, March.

Borensztein, E and U Panizza (2009): "The Costs of Sovereign Default," IMF Staff Papers, Palgrave Macmillan Journals, vol. 56(4), November

Brunnermeier, M and L Pedersen (2009): “Market liquidity and funding liquidity”, Review of Financial Studies, vol 22, pp 2201–38.

Cecchetti, S, M Mohanty and F Zampolli (2010): “The future of public debt: prospects and implications”, BIS Working Papers, no 300, March.

Cheun, S, I von Koppen-Mertes and B Weller (2009): “The collateral frameworks of the Eurosystem, the Federal Reserve System and the Bank of England and the financial market turmoil”, ECB Occasional Papers, no 107, December.

Chiodo, A and M Owyang (2002): “A case study of a currency crisis: the Russian default of 1998”, Federal Reserve Bank of St Louis.

Citigroup Global Markets (2011): “Hellenic banks: fancy a haircut?”, April.

Committee of European Banking Supervisors (2010), Stress test exercise, www.c-ebs.org/EuWideStressTesting.aspx.

Committee on the Global Financial System (2008): “Central bank operations in response to the financial turmoil”, CGFS Papers, no 31, Basel, July. ——— (2010): “The role of margin requirements and haircuts in procyclicality”, CGFS Papers, no 36, Basel, March

International Monetary Fund (2010): "Sovereigns, funding and systemic liquidity", Global Financial Stability Report, October.

International Monetary Fund and World Bank (2003): Guidelines for Public Debt Management, 9 December.

International Swaps and Derivatives Association (2010): ISDA Margin Survey 2010.

Jackwerth J C (2000): “Recovering Risk Aversion From Option Prices and Realized Returns”, Review of Financial Studies, 13(2), 433-451.

JPMorgan Chase (2010): “Where does Financials Senior go from here?”, 23 November.

Kaminsky, G and S Schmukler (2002): “Emerging markets instability: do sovereign ratings affect country risk and stock returns?” World Bank Policy Research Working Paper Series, no 2678.

Levy, A and A Zaghini (2010): “The pricing of government-guaranteed bank bonds”, Bank of Italy Working Papers, no 753, March.

Mody, A (2009): “From Bear Stearns to Anglo Irish: how eurozone sovereign spreads related to financial sector vulnerability”, IMF Working Paper, May

Moody’s (2007): Bank financial strength ratings: global methodology, February. ——— (2010a): “Moody's downgrades eight Portuguese banks following downgrade of Portuguese government to A1”, 14 July. ——— (2010b): “Moody’s downgrades Irish banks further to sovereign downgrade”, 20 December. ——— (2011): “Moody's downgrades the ratings of six Greek banks”, 9 March.

Nadal De Simone, F and F Stragiotti (2010): “Market and funding liquidity stress testing of the Luxembourg banking sector”, Central Bank of Luxembourg BCL Working Papers, no 45, May.

Panetta, F, T Faeh, G Grande, C Ho, M King, A Levy, F Signoretti, M Taboga and A Zaghini (2009): “An assessment of financial sector rescue programmes”, BIS Papers, no 48, July.

Reinhart, C and K Rogoff (2010): This time is different, Princeton University Press

Securities and Exchange Commission (2003): Report on the role and function of credit rating agencies in the operation of the securities markets, January

Sgherri, S and E Zoli (2009): “Euro area sovereign risk during the crisis”, IMF Working Papers, no 09/222, October.

Standard & Poor’s (2010a): “Ratings on five Portuguese banks and related subsidiaries lowered following downgrade of Portugal”, 27 April. ——— (2010b): “National Bank of Greece S.A.”, 29 October. ——— (2010c): “Irish bank ratings lowered, on CreditWatch negative, following sovereign downgrade”, 26 November.

Sy, A (2009): “The systemic regulation of credit rating agencies and related markets” World Economics no 10(4).

Vickers Report (2011): Interim report: consultation on reform options, Independent Commission on Banking, April.