Sovereign Exposures Research Articles

Recent evidence on the sovereign-bank nexus in the euro area

This paper estimates sovereign-bank default risk spillovers in the euro area. Spillovers spiked at the start of the COVID-19 pandemic and of the Russian invasion of Ukraine but remained contained during the March 2023 banking sector turmoil. Panel regressions find that higher banks’ sovereign exposures increase spillovers between the creditor bank and the borrowing sovereign. Countries with lower GDP growth, higher default probabilities, and a higher debt burden transmit more risk to banks. Larger, less capitalized and more funding-risk-exposed banks convey more default risk to sovereigns. Public aid to the financial sector reduces spillovers.

The Bright Side of the Doom Loop: Banks’ Sovereign Exposure and Default Incentives

The Bright Side of the Doom Loop: Banks’ Sovereign Exposure and Default Incentives

Deal! Market reactions to the agreement on the EU Covid-19 recovery fund

In response to the Covid-19 crisis, EU leaders agreed on the creation of a €750bn recovery fund (the Next Generation EU, NGEU). We investigate the short-term impact of this landmark deal on bank stocks, sovereign credit default swaps (CDS) and bank CDS. First, we find that stock market investors firmly welcomed the agreement as we find sizeable positive abnormal returns in bank stocks as a response to the NGEU proposal by the European Commission. Spreads on sovereign and bank CDS significantly declined, with more pronounced movements for heavily indebted countries and those that strongly advocated the creation of the recovery fund and for the banks located in these economies. Second, we show that banks’ sovereign exposures towards other European countries, especially those with weaker financial conditions and limited fiscal capacity, play a key role in driving the strength of the stock market reaction. Overall, financial markets responded positively to the credibility of the NGEU policy as an extraordinary common effort to support the post-Covid-19 recovery and enhance economic growth in the region.

The Bright Side of the Doom Loop: Banks’ Sovereign Exposure and Default Incentives

The Bright Side of the Doom Loop: Banks’ Sovereign Exposure and Default Incentives

Optimal bailouts and the doom loop with a financial network

Banks usually hold large amounts of domestic debt which makes them vulnerable to their own sovereign’s default risk. At the same time, governments often resort to costly bailouts when their banking sector is in trouble. We investigate how the network structure and the distribution of sovereign debt ownership within the banking sector jointly affect the optimal bailout policy under this “doom loop”. We argue that rescuing banks with high domestic sovereign exposure is optimal if these banks are sufficiently central, even though that requires larger bailout expenditures than rescuing otherwise identical low-exposure banks. Our model illustrates how the “doom loop” exacerbates the “too interconnected to fail” problem.

Sovereign Exposures of European Banks: It Is Not All Doom

We investigate whether sovereign bond holdings of European banks are determined by a risk–return trade-off. Using data between 2011 and 2018 for 75 European banks, we confirm that banks exhibited risk-taking behavior during the sovereign debt crisis, e.g., due to moral suasion. In the period 2015–2018, however, banks’ investments in sovereign bonds are characterized by sound risk–return considerations, suggesting a lessening of the doom loop. This result is mainly driven by banks in the core European countries, as banks in the GIPS countries do not exhibit such behavior, nor do they avoid riskier bonds following the sovereign debt crisis.

Implications of the Regulatory Treatment of Sovereign Exposures for Bank Behavior

Implications of the Regulatory Treatment of Sovereign Exposures for Bank Behavior

Home Bias in Sovereign Exposure and the Probability of Bank Default - Evidence from EU Stress Test Data

Since the European debt crisis economists and politicians discuss intensively the sovereign-bank nexus. The high activity in sovereign bond issuance required to mitigate the burden of the Covid19 crisis will rather intensify this debate than calm it down. Surprisingly, however, we still have only limited knowledge about the impact of a home bias in sovereign exposure on bank stability. This paper provides a new way to use European stress test data to study this relationship. In addition, we explore the effect on a bank’s probability of default if the existing capital requirement privilege for EU sovereign exposures were abolished. Our results support the conceptual idea behind the nexus theory. Interestingly, the effect of a home bias on bank stability is contingent on the home country’s solvency. If the home country is sufficiently solvent, investments in home sovereign bonds may improve bank stability. The findings clearly support the benefits of additional CET1 capital buffers. Regulation focusing on the home bias should account for heterogeneous effects depending on the home country’s solvency.

Banks’ Sovereign Exposures: In Search of New Rules

ABSTRACT In this article, we examine the reform of the prudential treatment of banks’ sovereign exposures with the purpose of introducing risk-sensitive capital charges and limiting home bias. We consider six different options and measure their impact on the common equity Tier 1 (CET1) ratio of 82 banks fom 10 euro-area countries, participating in the 2019 European Banking Authority EU-wide transparency exercise and subject to European Central Bank supervision. Our evidence shows that the proposal put forward by the Basel Committee on Banking Supervision in 2017 is the proposal which leads to the most evenly distributed impact across countries, in terms of CET1 ratio decline. That proposal targets the goals of risk sensitivity and diversification, with two independent instruments: rating-based risk weights and concentration add-ons. As a consequence, it is the only proposal which introduces an incentive for banks located in all countries, whether low rated or high rated, to reduce their home bias. Some proposals focus on one objective only: either risk sensitivity or diversification. Others introduce heavy penalization for banks located in low-rated countries, without addressing the home bias of banks located in high-rated countries. Several options are prone to pro-cyclicality, and we measure this effect by simulating the impact of a two-notch downgrading of high debt countries on the CET1 ratio of banks. Some relevant cross-country effects emerge from our analysis, due to the large cross-country exposures of a few intermediaries.

The impact of central bank liquidity support on banks’ sovereign exposures

ABSTRACT We empirically analyse the relationship between longer term central bank liquidity support and banks’ exposures to governments, using difference-in-differences panel regressions and propensity score matching on a large sample of banks in the euro area. The research question is whether the liquidity operations, which were introduced to prevent disorderly deleveraging, can also be linked to unintended changes in banks’ asset allocations, in particular to carry trades in government bonds. The results show that unconditional and conditional refinancing operations have a different effect on banks’ government exposures. Unconditional longer-term refinancing operations went together with more carry trades in stressed countries, i.e. banks borrowing more while increasing their holdings of government bonds. In contrast, refinancing operations that were conditional on banks’ lending were not associated with such carry trades, highlighting the benefits of conditionality attached to long-term refinancing operations.

Measuring and Pricing Cyclone-Related Physical Risk Under Changing Climate

We propose a statistical methodology to quantify the financial implications of tropical cyclone-related physical risks implied by climate change. To address the sensitivity of disaster intensity to climate change, we provide a Monte Carlo methodology to generate synthetic cyclones consistent with climate scenarios of the Couple Model Intercomparison Project (CMIP5). Sovereign exposure and vulnerability assessments in principal tropical cyclone basins are based on projections of population densities in shared socioeconomic pathways coupled with downscaled physical asset values constructed using mixed data along with locally calibrated damage functions. Finally, we compute the direct climate impact on emerging countries’ bond spreads using the spread sensitivity to the debt to GDP ratio, assuming that damage costs are financed by issuing new government debt. We find that the ‘business as usual’ RCP8.5 concentration scenario coupled with the ‘middle road’ shared socioeconomic pathway (SSP2) leads to global average annual damages 142% larger than in the concentration scenario RCP2.6 allowing to remain under 2°C warming. In terms of emerging market impact, we estimate that in 2070-2100, the impact of extreme cyclones on the bond spread of most vulnerable countries will up to 200 bps higher in the RCP8.5 pathway than in the 2°C baseline. In every step of our assessment, we quantify the impact of model uncertainty on our results using 7 different climate models from the CMIP5 database.

Bank Capital Regulation and the Sovereign-Bank Nexus: Evidence from European Banks

European sovereign debt benefits from privileges in banking regulation throughout all risk categories. In contrast to the risk-based approach applied to other asset classes, it does not have to be backed by equity, can be fully financed by short-term, unstable funding sources, is treated as liquid as cash and is not subject to exposure limits, regardless of its actual riskiness. We explore the effects of these regulatory privileges on the co-variation between sovereign and bank sector credit risks–the so-called sovereign-bank nexus. Examining sovereign bond portfolios of large European banks between 2010 and 2020, we show that additional capital buffers stemming from non-zero sovereign risk weights would indeed weaken the sovereign-bank nexus and thus serve as a reasonable starting point for the future regulatory treatment of sovereign debt. However, the impact of banks' domestic sovereign exposures is state-dependent and the sovereign-bank nexus is not strongest for banks with the highest risk-weighted sovereign exposures. As a result, the impact of capital requirements based on traditional risk-weighting schemes would be limited.

Systemic risk-efficient asset allocations: Minimization of systemic risk as a network optimization problem

Systemic risk is a multi-layer network phenomenon. Layers represent various types of direct financial exposure of various types, including interbank liabilities and derivative- or foreign exchange exposures. An important layer of systemic risk emerges through common asset holdings of financial institutions. Strongly overlapping portfolios lead to similar exposures that are caused by price movements of the underlying financial assets. Based on the knowledge of individual portfolio holdings of financial agents, we quantify the systemic risk of overlapping portfolios. We then present an optimization procedure whereby we minimize the systemic risk in a given financial market by optimally rearranging overlapping portfolio networks. The optimization is performed under the constraints that the expected returns and risk of the individual portfolios are unchanged. We explicitly demonstrate the power of the method on the overlapping portfolio network of sovereign exposure between major European banks, using data from the European Banking Authority stress test of 2016. Systemic risk can be reduced by more than a factor of two, without any detrimental effects for the individual banks. These results are confirmed by a simple simulation of fire sales in the government bond market. In particular, we show that the contagion probability is dramatically reduced in the optimized network. We comment on the efficiency of the network optimization approach in comparison to equity-injection-based ways to reduce systemic risk. To obtain the same risk levels that are obtained in the network optimization, it would be necessary to increase the actual available capital by two thirds. This shows the immense potential of network-based systemic risk management.

The missing European Deposit Insurance Scheme

The European Banking Union embarked as a highly ambitious project of the European Union as a response to the signifi cant fl aws and weaknesses in the original architecture of the European Monetary Union that became apparent during the economic crisis. However, the establishment of a single European banking system has stumbled upon the creation of a common deposit insurance scheme that could safeguard depositors and create a more stable fi nancial framework in the euro area. The European Deposit Insurance Scheme (EDIS) was fi rstly introduced by the European Commission in 2015. As a bold proposal that comprises wide risk mutualization among the euro area member states, it has spurred a vivid discussion in the European public speech and many proposals have been made since then altering its original planning in an effort to tackle the moral hazard concerns that have risen. The present article, after discussing the reasons that keep obstructing EDIS, presents these suggestions that move around, primarily, the role of the national deposit guarantee schemes. However, as highlighted in the article, before moving to any alterations on the structure and role of a proposed common deposit insurance scheme, signifi cant risk minimization on behalf of the national banking systems, must precede by limiting the sovereign exposures of banks and the size of the Non-Performing Loans. Such steps of risk minimization are critical for addressing concerns and the political unwillingness demonstrated by several European countries in moving forward towards deeper integration.

What drives banks’ appetite for sovereign debt in CEE countries?

In this paper, we provide the first analysis of the level and determinants of sovereign exposure of banking systems in Central and Eastern European (CEE) countries, thus contributing to the existing literature on sovereign exposures and the sovereign-bank nexus. Results of descriptive analysis showed that exposure to sovereign debt securities in CEE countries is substantially higher than in euro area countries, which can be explained by the lower development of financial markets in this region. We also found evidence of home-bias in CEE and emphasized the role of different monetary policy regimes in explaining differences in exposure among CEE countries. Results of panel analysis showed that changes of debt securities in bank balance sheets in CEE countries are mostly determined by broader macroeconomic conditions and to a lesser extent by their regulatory frameworks. In addition, we did not find evidence of so-called reach-for-yield behaviour. Our results indicate that efforts to reduce sovereign exposure in CEE countries require strong collaboration of not only regulators, but also of fiscal authorities and other policy makers able to contribute to the development of financial markets in this region. Moreover, regulators should especially focus on reducing the home-bias in CEE.

Reforming the Regulatory Treatment of Sovereign Exposures in Banking Regulation

Abstract The European sovereign debt crisis has shown the tight linkage between sovereign and bank balance sheets. In the aftermath of the crisis, several reforms have been discussed in order to mitigate the sovereign-bank nexus. These reforms include the abolishment of preferential government bond treatment in banking regulation. This paper gives a detailed overview of literature and data which are closely related to the existing preferential sovereign bond treatment in bank regulation and highlights the need for reforms especially in the euro area. Against this background, the following three regulatory reforms are described and discussed: (i) positive risk weights for government bonds in bank capital regulation, (ii) sovereign exposure limits, and (iii) haircuts for government bonds in bank liquidity regulation. The discussion focusses on the effects of these reforms for bank behaviour and financial stability. JEL Classification: H63, H12, G11, G18

Optimal Bailouts and the Doom Loop with a Financial Network

Banks usually hold large amounts of domestic public debt which makes them vulnerable to their own sovereign’s default risk. At the same time, governments often resort to costly public bailouts when their domestic banking sector is in trouble. We investigate how the interbank network structure and the distribution of sovereign debt holdings jointly affect the optimal bailout policy in the presence of this doom loop. Rescuing banks with high domestic sovereign exposure is optimal if these banks are sufficiently central in the network, even though that requires larger bailout expenditures than rescuing low-exposure banks. Our findings imply that highly central banks can use exposure to their own government as a strategic tool to increase the likelihood of being bailed out. Our model thus illustrates how the doom loop exacerbates the too interconnected to fail problem in banking. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Sovereign Asset and Liability Management in Emerging Market Countries

This paper provides an overview of the strategic and operational issues as well as institutional challenges, related to the implementation of the Sovereign Asset and Liability Management (SALM) approach. Application of an SALM framework allows the authorities to identify and monitor sovereign exposure mismatches; increase resilience to foreign currency and interest rate risks; and thus, strengthen financial stability; and implement more cost-effective management of the public-sector debt. The analysis is based on emerging market (EM) countries and illustrated by the experience of Uruguay, using data as of end-2017.

A Simple Sovereign Default Model

A very influential model in the determination of capital requirements for credit exposures is Vacisek’s model. This model underpins the Basel framework for credit exposures of financial institutions. Vacisek’s model uses information on asset correlation and the unconditional mean of the probability of default to derive the conditional probability of default under stress. However, the concept of asset values applies best to corporations rather than to sovereign exposures. We adapt Vacisek’s model to capture the event of a sovereign default that results from a country hitting certain thresholds of economic distress. A reasonable assumption is that a significant drop in foreign reserve assets triggers the default event in a developing country as observed during the 1980s debt crisis, in which highly indebted Latin American countries and other developing regions were unable to repay the debt.

Sovereign stress and heterogeneous monetary transmission to bank lending in the euro area

Is the transmission of monetary policy to bank lending heterogeneous across the euro area? This article employs bank and loan level data over the period 2007–2016 to test the bank lending channel of monetary policy by focusing on similar banks located in different countries. Results indicate the presence of heterogeneity in that the transmission of both conventional and unconventional monetary policy to bank lending appears to be weaker for banks located in countries more exposed to the sovereign debt crisis. Exposure to sovereign risk is identified as a key source of heterogeneity: within sovereign stressed countries, banks with higher sovereign exposures react to monetary easing by expanding lending by less than banks with lower exposures. These findings add to existing evidence on the impact of sovereign risk on credit supply and establish a direct link between banks’ sovereign exposure and cross-country heterogeneity in the transmission of monetary policy to bank lending in the euro area.