Sovereign Risk Spill-Overs to Banking Sectors in Central America and the Caribbean

Abstract

Banking regulations (such as, risk-based capital framework and reserve requirements) have had the unintended consequence of incentivizing banks to hold more sovereign debt on their balance sheets than suggested by their strategic motives. As a result, bank stability now depends more heavily than before on the creditworthiness of governments. Despite this new reality, the impact of sovereign credit ratings on bank stability is still hotly debated in the Financial Economics literature. As this debate ensues little is known about the impact of sovereign credit ratings on bank stability in the Central American and Caribbean context, where sovereign debt crises have been frequent. This paper, therefore, examines the impact of sovereign credit ratings on bank stability as measured by non-performing loans (NPLs), in the Central American and Caribbean region. We use bank data on 24 countries from Central America and the Caribbean spanning the period from 1998–2014. Our results highlight the presence of a significant impact of sovereign rating downgrades on bank stability. The risk spill-over is particularly pronounced in countries that are externally vulnerable, measured by the degree of global exposure, and where financial disclosure requirements are weak. This strongly supports the global coordinated approach on macroprudential oversight.