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The sovereign-bank nexus – Holistic solution needed to end a vicious cycle

Since the financial crisis of 2008, numerous emerging and developed countries experienced a substantial increase to their government gross debt-to-GDP ratio (sovereign debt). In addition, there were significant increases in the ratio of non-performing loans (NPLs) to total loans in the banking systems during a similar timeframe, thereby adding to regulatory concerns. While the circumstances and reasons can vary for every particular case, it is generally accepted that increases to sovereign debt and NPLs are interdependent.

The close ties between the health of the banking system and the level of sovereign debt in a state is often termed as the sovereign-bank nexus. A crucial point is that negative developments in one area can often affect another, thereby creating a vicious cycle. Once the sovereign-bank vicious cycle is in full swing, the government would often have to invest extraordinary efforts and resources in order to break it.

On the one hand, an increase of NPLs leads to the deterioration of the balance sheets of banks, and in an extreme scenario could lead to a need for resolution of the relevant bank. If the troubled bank could pose a systemic risk to the financial stability of the country, a government could intervene by rescuing the bank to avoid further contamination of the financial system and a potential bank crisis. As seen in the financial crisis, a bail out of the troubled bank(s) using public funds almost invariably leads to an upsurge of sovereign debt.

On the other hand, expansion of sovereign debt beyond sustainable levels often puts significant tensions on banks. For instance, losses on government bonds or other sovereign exposures, which are generally considered by banks and regulators as "safe havens" in terms of capital requirements, could unexpectedly impair banks' balance sheets and increase financing costs through the requirement of additional capital injections. Furthermore, fiscal problems caused or exacerbated by unsustainable levels of sovereign debt are often considered as determining factors to the sharp increase of bank NPLs and the troubles in the banking sector in general.

Further, the troubles in the financial system could easily spill over to the real economy. In fact, this is another form of vicious cycle. In essence, decreased lending by banks, in particular due to tied-up capital to hold NPLs, triggers a reduction in the national economy or event decline of economic growth and consequently tax revenue. This results in an additional pressure on the ability of a state to repay sovereign debt. Unsurprisingly, credit rating agencies consider NPLs as an important driver of sovereign credit ratings and vice versa.

According to the most recent Basel III Monitoring Report 'the share of sovereign exposures has increased steadily in recent years from 12.4% to 19.9%' in a sample of 36 large and internationally active banks. Recognising the importance of the sovereign-bank nexus, the Basel Committee on Banking Supervision (BIS) is currently discussing various options for the regulatory treatment of sovereign exposures. The problem stems from the fact that the Basel III accord left sovereign risk largely unaddressed since a zero per cent. (0%) risk-weight is applied to sovereign bonds on bank balance sheets regardless of the actual economic conditions.

However, the regulatory treatment of sovereign exposures is a politically sensitive topic. Even a soft approach recently proposed by the BIS to introduce voluntary disclosure of sovereign exposures to the public, which are already available to supervisors, under Pillar 3 of the Basel Framework for internationally active banks is highly contested.

Similarly, various EU bodies are actively discussing the treatment of banks' exposures to sovereign risks. Yet, the proposals are more radical in nature than the one discussed by the BIS. For instance, the European Banking Authority, in contrast to the BIS, has recommended a mandatory disclosure framework for sovereign exposures. Moreover, the Eurogroup High Level Working Group on European Deposit Insurance Scheme (EDIS), in its recent roadmap for political negotiations regarding strengthening the Banking Union, called for a further study of the introduction of concentration charges on sovereign exposures in implementing risk-based contributions to EDIS.

Therefore, it is necessary to approach a bank-NPL resolution, being important for the credit risk of banks, in parallel with tackling sovereign debt issues, since both are detrimental to the safety and soundness of financial institutions. It is hardly possible to imagine better circumstances to apply the proverb – "Prevention is better than cure." In this regard, every case usually has a unique combination of different factors and therefore requires a bespoke solution involving understanding of and expertise in: NPL resolution and securitisation, bank regulation and insolvency procedures, state aid and sovereign debt management.

As the current coronavirus outbreak shows, it is also of utmost importance to keep the banking system and the level of sovereign debt in good shape to be able to respond to "black swan" events. In extraordinary times, public sector support is essential to underpin the economy and avert economic crisis. In this regard, the European Commission, presided over by Ursula von der Leyen, is contemplating a targeted approach to mitigate the impact of coronavirus through various fiscal stimuli. Further, there is a proposal by the French Finance Ministry to extend the amount of time when banks should classify a loan as non-performing to provide businesses with a break from repayments and to relieve banks from higher capital requirements due to NPLs. Inevitably, the public sector measures will put the sovereign-bank nexus under stress and its robustness is essential to support the economy in times when needed.

 

Grygoriy Pustovit and Reetu Vishwakarma also contributed to this article.

 

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