## CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE

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### Introduction and chapter at a glance
- Holdings by banks of domestic sovereign debt have surged in emerging markets during the COVID-19 pandemic, on average accounting for about one-fifth of banking sector assets and 200 percent of their regulatory capital.
- The larger holdings have deepened the sovereign-bank nexus; with public debt at historically high levels and the sovereign credit outlook deteriorating in many emerging markets, a deeper nexus poses risks of an adverse feedback loop that could threaten macro-financial stability.
- The chapter examines:
  - How the link between the sovereign and banking sector evolved, and how the COVID-19 pandemic affected that link; and what factors motivate the banking sector to hold sovereign debt.
  - How strong the sovereign-bank nexus is and how it is affected by adverse shocks such as a tightening in global financial conditions.
  - The relative relevance of transmission channels: direct transmission from sovereign holdings, the role of government guarantees and safety nets, and the indirect transmission through the corporate sector.
- Policy response recommendations highlighted:
  - Better targeting of spending and strengthening of medium-term fiscal frameworks in countries with limited fiscal space and tight borrowing constraints.
  - Preserving bank resources to absorb losses by restricting capital distribution where needed.
  - Conducting bank stress tests that take into account the multiple channels of the nexus.
  - Examining options to weaken the nexus—such as capital surcharges on banks’ holdings of sovereign bonds above certain thresholds—once recovery has taken hold and pandemic-related support measures have been withdrawn.
  - Continuing efforts to foster a deep and diversified investor base to strengthen market resilience where local currency bond markets are underdeveloped.
- Disclosure recommendation:
  - To foster market discipline, banks should be mandated to disclose data on all material sovereign exposures.

### Recent developments and drivers
- Public debt and bank exposures:
  - The average public-debt-to-GDP ratio in emerging markets surged to a record 67 percent in 2021 from about 52 percent before the pandemic.
  - Banks’ domestic sovereign debt exposure reached 17 percent of total banking sector assets in 2021.
- Role of banks and market dynamics:
  - Additional government financing needs in emerging markets have been met mostly by domestic banks amid declining foreign participation in local currency bond markets and a generally limited domestic investor base.
  - Local currency government bond yields have increased for most emerging markets in recent months as foreign participation in local currency bond markets has declined, while central banks have tightened monetary policy on the heels of rising inflationary pressures.
- Fiscal support during COVID-19:
  - The discretionary fiscal response to the pandemic averaged about 10 percent of GDP during 2020–21—of which 6 percent consisted of additional spending and forgone revenues and 4 percent consisted of equity, loans, and guarantees.
- Sample and data:
  - The core sample of emerging markets comprises 53 economies.

### Transmission channels and interactions
- Three key channels linking sovereign and banking stress:
  - Sovereign exposure channel:
    - Direct exposure of banks to sovereign risk through holdings of government debt; a rise in sovereign spreads could reduce market values of government debt that banks hold and use as collateral, leading to higher funding costs and liquidity strains.
  - Safety net channel:
    - Government support via implicit and explicit guarantees; sovereign stress could reduce funding benefits from the safety net and increase fiscal contingent liabilities if guarantees are activated or if governments hold substantial bank equity.
  - Macroeconomic channel:
    - Sovereign stress can lead to lower spending and transfers, economic slowdown, downward pressure on corporate ratings, tighter lending and funding conditions, crowding out, lower tax revenues, higher contingent liabilities—driving higher nonperforming loans and funding costs in banks.
- Feedbacks and amplification:
  - Mark-to-market losses on sovereign bond holdings can raise banks’ funding costs, while weaker backstops and higher funding costs for banks can reduce demand for sovereign bonds and raise sovereign funding costs, creating a mutually reinforcing “doom loop.”
  - Well-capitalized banks can act as shock absorbers, but overreliance of governments on domestic banks concentrates the investor base and amplifies risks.

### Stylized facts and heterogeneity
- Trends in bank sovereign holdings:
  - Domestic banks’ share in sovereign debt holdings increased from an average of about 20 percent two decades ago to more than 30 percent in 2020.
  - Cross-country variation: examples given range from about 5 percent of banking sector assets (Chile and Peru) to more than 25 percent (Brazil and Pakistan); China exceeds 80 percent in some measures; Uruguay below 10 percent.
- Motivations for banks to hold sovereign debt:
  - Liquidity management, expected returns and limited alternative investment opportunities, market-making roles, collateral for central bank funding, regulatory treatment (zero risk weights), moral suasion, and risk shifting during distress.
- Nonbank financial institutions:
  - Hold a nontrivial share of public debt in some emerging markets but financial systems remain largely bank-based; lack of detailed data limits in-depth analysis.

### Measurement and empirical evidence
- Methods and samples:
  - Two-way relationships between sovereign, banking, and corporate sector default risks assessed using expected default frequency (EDF) measures and panel quantile regressions with country fixed effects.
  - Structural value-at-risk model estimated for 15 emerging markets using 2006–20 data.
  - Bank-level panel sample: 525 banks based in 18 emerging markets over 2000–20.
- Key statistical findings:
  - At low levels of bank distress, a 1 percentage point increase in sovereign default risk is associated with a 0.4 basis point increase in banks’ expected default frequency; at higher levels of bank distress the association is 10 times stronger.
  - Correlation between sovereign and bank default risk rises markedly when global financial conditions are strained (e.g., global financial crisis and March 2020 market turmoil).
  - Median time-varying correlations among sovereign, bank, and nonfinancial corporate sector stress increase when global financial conditions tighten (24-month rolling window correlations).
  - Panel analyses show increasing strength of the correlation between changes in sovereign and bank default risk at higher percentiles of bank stress.
  - After a sharp tightening in global financial conditions, emerging markets with higher public debt and banks’ holdings of sovereign debt experience an increase in sovereign and bank default risks that is twice as large as the average increase; the impact remains larger than average for up to six quarters.

### Mark-to-market sovereign bond exposures and scenario analysis
- Mark-to-market exposure:
  - A sizable share of domestic government bond holdings is marked to market in major emerging markets, exposing banks to market risk.
  - In several emerging market regions, a haircut of about 30–40 percent would breach the minimum CET1 capital ratio.
- Scenario methodology and thresholds:
  - The scenario haircut that would breach the 4.5 percent minimum regulatory common equity Tier 1 (CET1) capital ratio is computed assuming other sources of capital are unavailable; the value is taken as a median across banks in individual economies and over regions.
  - Historical haircut reference: Cruces and Trebesch (2013) estimate a 37 percent average haircut for countries during 1978–2010 and a 50 percent average haircut during 1998–2010; historical loss data sample covers 68 economies during 1970–2010.
- Vulnerabilities and buffers:
  - Banking systems in sub-Saharan Africa are relatively more vulnerable to sovereign distress; haircuts as small as 30 percent would breach the minimum CET1 capital ratio in domestic banks in the region.
  - Sovereign holdings of international reserves act as a buffer: domestic banks in countries with a higher stock of foreign exchange reserves relative to short-term external debt experience a significantly smaller decline in capital during intense sovereign stress.
- Quantified bank-level effects:
  - Sovereign distress defined as an explicit default or monthly average sovereign CDS spreads higher than 500 basis points within the same year.
  - Banks with a 10 percentage point higher ratio of government debt holdings to total bank assets (relative to average bank holdings) face an expected default frequency that is, on average, 0.4 percentage point higher.
  - The average expected default frequency in the bank sample is 1.2 percent.
  - Effects on default risk, bank lending, and capitalization grow as sovereign distress deepens; the impact on banks’ equity is more than twice as large when sovereign spreads reach 1,000 basis points.
  - Banks with higher sovereign debt exposure cut back on lending more than peers following sovereign distress.
  - Banks with an average capital ratio that are more exposed further increase their holdings of government debt when the sovereign is in distress, consistent with crowding-out effects.

### Safety net, moral hazard, and banking behavior
- Government support and support rating floors:
  - Bank-level estimates of government support use support rating floors from Fitch converted to a numerical scale of 1–17 (higher values correspond to a higher rating or higher likelihood of receiving government support).
  - On average, government support proxied through support rating floors is greater in emerging markets than in advanced economies, and it has generally increased since the global financial crisis.
  - There is a strong positive relationship between bank size and government support ratings, implying large implicit subsidies for banks that are “too big to fail.”
  - Banks with higher support rating floors tend to have lower capital ratios and a majority government stake, pointing to potential moral hazard.
- Market reactions and performance:
  - Equity returns of emerging market banks in times of sovereign distress are higher for banks whose support rating floor is one notch higher than that of their peers; the positive effect before sovereign distress declines over time, turning negative six months after the shock.
  - Banks with a higher support rating floor but lower capital expand their loan portfolios more aggressively, with cumulative credit growth about 8 percentage points higher than that of other banks two years after the distress event.
  - Banks with both a lower capital ratio and a higher support rating experience a significant jump in nonperforming loans in the medium term.
- Sample for banking-sector analyses:
  - Composed of 10 major emerging markets covering the period 2007–20.

### Macroeconomic (corporate) channel and spillovers
- Identification and corporate effects:
  - Exploits rating-ceiling policies by comparing “bound firms” (rating equal to or above the sovereign before the downgrade) with “unbound firms” (rating lower than the sovereign).
  - A bound firm’s cumulative investment drops nearly 17 percentage points more than an unbound firm’s cumulative investment two years after a sovereign downgrade.
  - The effect on investment is significantly larger if the sovereign downgrade is accompanied by higher sovereign stress (sovereign CDS spreads greater than 500 basis points).
  - Low sovereign risk defined as periods with a sovereign CDS spread between 250 and 500 basis points; high sovereign risk defined as periods with a sovereign CDS spread greater than 500 basis points.
- Spillovers to banks:
  - Following a sovereign downgrade, banks’ nonperforming loans increase more in economies where bound firms play a larger role in the corporate sector.
  - A one standard deviation higher share of assets of bound firms in economy-wide corporate assets is associated with a 1 percentage point greater change in nonperforming loans two years after the sovereign downgrade.
- Downgrade sample:
  - Composed of 100 sovereign debt downgrades in 29 countries during 1998–2020 (years with banking crises in which the country was downgraded are excluded).

### Policy recommendations and reforms
- Fiscal and sovereign-debt policy:
  - Countries with stronger fiscal positions and a sound banking system should seek to extend maturities of public debt where feasible and avoid a further buildup of currency mismatches.
  - In countries with limited fiscal space and tight borrowing constraints:
    - improve the efficiency and targeting of fiscal spending to support recovery; and
    - embed fiscal policy in credible and sustainable medium-term fiscal plans to mitigate the impact of an adverse shock.
  - Develop robust resolution frameworks for sovereign debt to facilitate orderly deleveraging and restructuring; domestic debt restructurings may become more frequent given the increase in the share of domestic debt in total public debt in emerging markets.
- Financial sector policies:
  - Preserve banks’ resources to absorb potential losses by limiting capital distribution where bank profitability is difficult to assess because of regulatory flexibility.
  - Asset quality reviews may be necessary to quantify hidden losses and identify weak banks once forbearance has ceased; results should guide supervisory actions requiring more robust levels and quality of bank capital, phased in over time in a preannounced manner to minimize procyclical effects.
  - Strengthen private debt resolution frameworks where corporate bankruptcy frameworks are inadequate.
  - Improve transparency and data quality of banks’ holdings of government debt (by currency denomination and account classification); require disclosure as necessary for meaningful market discipline.
  - Consider requiring banks to cover risks of significant sovereign exposures in stress tests by taking into account multiple channels of the nexus.
  - When recovery permits, consider measures aimed at reducing incentives to hold excessive sovereign debt, such as:
    - nonzero, risk-sensitive capital requirements for sovereign exposures; or
    - calibrated capital surcharges on bank holdings of domestic sovereign bonds above certain thresholds that account for liquidity needs and availability of other liquid assets in domestic currency.
  - Strengthen banking crisis management frameworks (deposit guarantee programs, resolution regimes, central bank liquidity facilities) and prepare contingency plans detailing authorities’ responses to potential future pressures.
  - Ensure effective governance, regulation, and supervision of public banks; deposit-taking public banks directly competing with private banks should be subject to the same expectations and requirements of governance and prudential standards.
- Ownership, governance, and market structure reforms:
  - Promote arm’s length mechanisms between government ownership and bank management; separate ownership roles from supervisory authority roles.
  - Promote a deep and diversified investor base including institutional investors to spread risk in government debt portfolios and extend the yield curve.
  - Recognize that a highly concentrated banking sector can undermine incentives to trade and impede market liquidity; nonbank investors (pension funds, insurance companies) generally prefer longer-dated assets and facilitate issuance of longer-dated securities.

### Selected exact figures and thresholds (preserved)
- Banks’ domestic sovereign debt exposure in 2021: 17 percent of total banking sector assets.
- Average public-debt-to-GDP ratio in emerging markets: 67 percent in 2021; about 52 percent before the pandemic.
- Discretionary fiscal response to the pandemic: about 10 percent of GDP during 2020–21 (6 percent additional spending and forgone revenues; 4 percent equity, loans, and guarantees).
- Core sample of emerging markets: 53 economies.
- Median capital adequacy ratio across emerging markets: 14 percent in 2020.
- Minimum regulatory CET1 capital ratio referenced: 4.5 percent.
- Haircut breaching minimum CET1: about 30–40 percent.
- Historical haircut averages (Cruces and Trebesch (2013)): 37 percent (1978–2010) and 50 percent (1998–2010); historical loss sample: 68 economies during 1970–2010.
- Structural value-at-risk model sample: 15 emerging markets, 2006–20.
- Bank-level panel sample: 525 banks, 18 emerging markets, 2000–20.
- Median CDS spread in bank sample: about 250 basis points.
- Sovereign distress thresholds used: monthly average sovereign CDS spreads higher than 500 basis points; sovereign spreads reaching 1,000 basis points used to illustrate deeper distress.
- Quantified effect: 10 percentage point higher bank government debt holdings → 0.4 percentage point higher expected default frequency.
- Average expected default frequency in bank sample: 1.2 percent.
- High vulnerability definitions: one standard deviation above sample average equivalent to about 80 percent (public debt) and 20 percent (bank sovereign exposure); mean values about 50 percent (public debt) and 9 percent (bank sovereign exposure).
- Country examples of bank sovereign holdings: about 5 percent (Chile, Peru) to more than 25 percent (Brazil, Pakistan); state-owned banks on average held about 30 percent of total banking sector assets in major emerging markets in 2020; the ratio exceeded 40 percent in some countries.
- “Less capitalized” banks threshold: equity-to-assets ratio one standard deviation below the mean, which is about 7 percentage points.
- High fiscal need cutoff: top 75th percentile of maturing sovereign debt (to lagged total debt) distribution.
- Downgrade sample: 100 sovereign debt downgrades in 29 countries during 1998–2020.

*Source: Chapter 2, “The Sovereign–Bank Nexus in Emerging Markets: A Risky Embrace,” Global Financial Stability Report, April 2022.*

### Introduction

### ch2 - Introduction

### Chapter 2 at a Glance
- Holdings by banks of domestic sovereign debt have surged in emerging markets during the COVID-19 pandemic, on average accounting for about one-fifth of banking sector assets and 200 percent of their regulatory capital.
- The larger holdings of domestic sovereign debt by emerging market banks have deepened the ties between the sovereign and banking sectors—the so-called sovereign-bank nexus. With public debt at historically high levels and the sovereign credit outlook deteriorating in many emerging markets, a deeper nexus poses risks of an adverse feedback loop that could threaten macro-financial stability.
- This chapter examines the sovereign-bank nexus in emerging markets, focusing especially on the COVID-19 pandemic, and puts forward policy options to minimize its potential risks and enhance resilience.
- The transmission of risks between the sovereign and banking sectors is significant—both directly and indirectly through the nonfinancial corporate sector.
- An increase in sovereign risk can adversely affect banks’ balance sheets and lending appetite, especially in countries with less-well-capitalized banking systems and higher fiscal vulnerabilities. It can also constrain funding for the nonfinancial corporate sector and reduce its capital expenditure.
- Policy response recommendations include:
  - Better targeting of spending and strengthening of medium-term fiscal frameworks in countries with limited fiscal space and tight borrowing constraints to build resilience and mitigate the impact of an adverse shock
  - Preserving bank resources to absorb losses by restricting capital distribution where needed
  - Conducting bank stress tests by taking into account the multiple channels of the nexus
  - Examining options to weaken the nexus—such as capital surcharges on banks’ holdings of sovereign bonds above certain thresholds—once the economic recovery has taken hold and pandemic-related financial sector support measures have been withdrawn
  - Continuing efforts to foster a deep and diversified investor base to strengthen market resilience in countries with underdeveloped local currency bond markets
- Given that risks from the sovereign-bank nexus are not limited to emerging markets but have also manifested in advanced economies in the past, the Basel Committee on Banking Supervision could consider resuming its efforts to develop international standards that reflect a more risk-sensitive regulatory and supervisory treatment. To begin with, and in order to foster market discipline, banks should be mandated to disclose data on all material sovereign exposures.

### Developments and Drivers
- Public debt and banks’ sovereign exposures:
  - The average public-debt-to-GDP ratio in emerging markets surged to a record 67 percent in 2021 from about 52 percent before the pandemic.
  - Banks’ domestic sovereign debt exposure reached 17 percent of total banking sector assets in 2021.
- Role of banks in financing sovereigns:
  - Additional government financing needs in emerging markets have been met mostly by domestic banks amid declining foreign participation in local currency bond markets and a generally limited domestic investor base.
- Fiscal support to the corporate sector during COVID-19:
  - The discretionary fiscal response to the pandemic averaged about 10 percent of GDP during 2020–21—of which 6 percent consisted of additional spending and forgone revenues and 4 percent consisted of equity, loans, and guarantees.
- Sample and data:
  - The core sample of emerging markets comprises 53 economies.

### Risks, Vulnerabilities, and Recent Trends
- Emerging markets face higher fiscal vulnerabilities relative to advanced economies:
  - Growth prospects are generally weaker relative to the pre-pandemic trend in emerging markets compared with advanced economies.
  - Governments’ ability to support the economic recovery (fiscal space) is more limited, with a higher debt-servicing burden.
- Refinancing and currency risks:
  - Refinancing risks are higher in emerging markets given the shorter average maturity profile of public debt, a higher share of public debt denominated in foreign currency (especially in US dollars), and rising sovereign spreads amid a worsening sovereign credit outlook.
- Market and monetary dynamics:
  - Local currency government bond yields have increased for most emerging markets in recent months as foreign participation in local currency bond markets has declined, while central banks have tightened monetary policy on the heels of rising inflationary pressures.
- Interactions that could trigger adverse feedback loops:
  - A sharp tightening in global financial conditions, intensifying geopolitical tensions, or domestic shocks (for example, a weaker-than-anticipated economic recovery or new COVID-19 variants) could push emerging market borrowing costs higher and trigger an adverse feedback loop between sovereign and banking sectors.
  - Countries whose banks are more exposed to sovereign debt are also those with a higher public-debt-to-GDP ratio and lower bank capital ratios.

### Sovereign-Bank Transmission Channels (Conceptual Framework)
- The sovereign and banking sectors are connected through three key channels that can transmit and amplify shocks:
  - Sovereign exposure channel:
    - Direct exposure of banks to sovereign risk through holdings of government debt. A rise in sovereign spreads could reduce the market value of government debt that banks hold and use as collateral, leading to higher funding costs and liquidity strains for banks.
  - Safety net channel:
    - Government support to banks via implicit and explicit guarantees. Sovereign stress could reduce funding benefits from the safety net, threatening bank stability and potentially increasing fiscal contingent liabilities if guarantees are activated or if governments hold substantial bank equity.
  - Macroeconomic channel:
    - Sovereign stress can lead to lower spending and transfers, economic slowdown, downward pressure on corporate ratings, tighter lending and funding conditions, crowding out, lower tax revenues, and higher contingent liabilities—driving higher nonperforming loans and funding costs in banks.
- These channels interact: For example, mark-to-market losses on sovereign bond holdings can raise banks’ funding costs, while weaker backstops and higher funding costs for banks can reduce demand for sovereign bonds and raise sovereign funding costs.

### Analytical Focus and Key Questions
- The chapter investigates:
  - How the link between the sovereign and banking sector evolved, and how the COVID-19 pandemic affected that link; and what factors motivate the banking sector to hold sovereign debt.
  - How strong the sovereign-bank nexus is and how it is affected by adverse shocks such as a tightening in global financial conditions.
  - The relative relevance of transmission channels: direct transmission from sovereign holdings, the role of government guarantees and safety nets, and the indirect transmission through the corporate sector.

*Source: ch2 - Introduction*

### CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE

### CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE

### Channels of interaction between sovereigns, banks, and the macroeconomy
- Three main channels linking sovereign and banking stress:
  - Direct balance-sheet channel: sovereign distress can reduce sovereign debt market values and impair bank capital through holdings of government debt.
  - Funding and market-liquidity channel: sovereign stress can disrupt government bond markets and funding conditions, affecting banks’ liquidity and funding costs.
  - Indirect macroeconomic/corporate channel: sovereign weakening can raise borrowing costs, prompt fiscal consolidation, or increase policy uncertainty, hurting the corporate sector and, through deteriorated loan portfolios and higher provisioning, feeding back onto banks and sovereigns.
- Feedbacks can work in reverse: banking-sector stress can cause sovereign stress by disrupting government bond markets, activating fiscal backstops, or dampening economic activity.
- These channels often interact and amplify each other, creating a mutually reinforcing “doom loop.”
- Well-capitalized banks can act as shock absorbers by being stable buyers of sovereign debt, but overreliance of governments on domestic banks concentrates investor base and amplifies risks.

### Role of nonbank financial institutions
- Domestic nonbank financial institutions can transmit sovereign or banking risk to other sectors through direct and indirect exposures to banks and firms.
- Nonbank financial institutions hold a nontrivial share of public debt in some emerging markets (see Online Annex), but financial systems in emerging markets remain largely bank-based.
- Lack of detailed data on sovereign debt holdings and interconnectedness of different types of nonbank financial institutions limits in-depth analysis.

### Stylized facts on sovereign-bank linkages in emerging markets
- Domestic banks’ share in sovereign debt holdings:
  - Increased from an average of about 20 percent two decades ago to more than 30 percent in 2020.
  - Substantial cross-country variation: in some economies (such as Uruguay), banks hold less than 10 percent of total sovereign debt, while in others (such as China) this share exceeds 80 percent.
- Drivers of banks’ sovereign exposure include liquidity management, higher interest rates, lower financial sector development, and government moral suasion.
- Empirical association between sovereign and bank default risk:
  - At low levels of bank distress, a 1 percentage point increase in sovereign default risk is associated with a 0.4 basis point increase in banks’ expected default frequency.
  - At higher levels of bank distress, the association is 10 times stronger.
  - Correlation between sovereign and bank default risk rises markedly when global financial conditions are strained (e.g., during the global financial crisis and March 2020 COVID-19 market turmoil).
- The sovereign–bank nexus has amplified past crises:
  - Banking and sovereign debt crises have frequently occurred together in emerging markets.
  - Banking sector deterioration (peak NPLs) and fiscal costs of banking crises have been significant in emerging markets and on par with advanced economies in fiscal cost measures.
  - Deterioration in credit quality (share of nonperforming loans) during banking crises has been twice as large in emerging markets as in advanced economies.

### Deepening of the nexus during the COVID-19 pandemic
- Banks’ holdings of local currency government debt increased significantly as a share of their assets during the pandemic.
- State-owned banks were major buyers of government debt in several countries, though private domestic banks also contributed.
- Excess liquidity driven by weaker credit demand and a surge in deposits was associated with increased sovereign bond purchases by banks.
- Banking system capitalization and sovereign exposure:
  - Median capital adequacy ratio across emerging markets stood at 14 percent in 2020.
  - Sovereign debt exposure constitutes a significant share of regulatory capital in some countries; in several emerging markets a sizable share of banks’ outstanding sovereign debt holdings follows mark-to-market accounting.
  - Rising global yields and monetary policy normalization in advanced economies reduce market values of bond holdings and can undermine bank capital.
- Scenario analysis findings:
  - Minimum haircuts on banks’ holdings of domestic sovereign debt that would lead to a breach of the 4.5 percent minimum regulatory common equity Tier 1 (CET1) capital ratio were computed.
  - Taking the median haircut across banks in a region, banking systems in sub-Saharan Africa are relatively more vulnerable to sovereign distress.
  - Haircuts as small as 30 percent would breach the minimum CET1 capital ratio in domestic banks in the region; such haircuts are probable and have been observed in the past.
  - For context, Cruces and Trebesch (2013) estimate a 37 percent average haircut for countries during 1978–2010 and a 50 percent average haircut during 1998–2010.
- Corporate sector strains:
  - Sustainability of corporate debt (earning capacity relative to debt) declined as corporate revenues fell in most emerging markets during the pandemic.
  - Nonperforming loans are more than one-tenth of total loans in some countries and could increase as loan-repayment moratoria and support measures are unwound.
- Sovereign and bank credit risk remain closely tied, reflected by a positive correlation between sovereign and bank credit ratings.

### Measurement and assessment of the nexus
- The chapter evaluates two-way relationships between sovereign, banking, and corporate sector default risks using expected default frequency (EDF) measures and panel quantile regressions with country fixed effects.
- Statistical evidence:
  - Panel analyses show increasing strength of the correlation between changes in sovereign and bank default risk at higher percentiles of bank stress.
  - Median time-varying correlations among sovereign, bank, and nonfinancial corporate sector stress increase when global financial conditions tighten (24-month rolling window correlations).

*Source: CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE (PDF).*

### 4. Share of Mark-to-Market Sovereign Bonds

### 4. Share of Mark-to-Market Sovereign Bonds

### Key findings on mark-to-market sovereign bond exposure
- A sizable share of domestic government bond holdings is marked to market in major emerging markets, exposing banks to market risk.
- A haircut of about 30–40 percent would breach the minimum CET1 capital ratio in some regions.
- The scenario haircut that would breach the 4.5 percent minimum CET1 capital ratio is computed assuming other sources of capital are unavailable; the value is taken as a median across banks in individual economies and over regions.
- The historical haircut corresponds to the average direct loss given default rates for sovereign debt holders across 68 economies during 1970–2010 as reported in Cruces and Trebesch (2013).

### Sovereign-bank nexus: transmission and heterogeneity
- Three key findings emerge:
  - The nexus is strong on average, with significant feedback effects between sectors.
  - Spillovers from sovereign default risk to banks are, on average, larger than those from banks to sovereign default risk; overall, the largest spillovers are from sovereign and bank default risk to firms.
  - The strength of transmission varies across countries; in some cases transmission of shocks is three to five times higher than the average.
- Empirical setup and sample details:
  - A structural value-at-risk model is estimated for 15 emerging markets using 2006–20 data; identification uses Rigobon’s (2003) methodology.
  - Dependent variable: expected default frequency (proxy for default risk) for sovereign, banking, and corporate sectors.
- Quantitative evidence:
  - An increase in sovereign, bank, and nonfinancial corporation default risk transmits across sectors with varying intensity (see Figure 2.8).
  - After a sharp tightening in global financial conditions, emerging markets with higher public debt and banks’ holdings of sovereign debt experience an increase in sovereign and bank default risks that is twice as large as the average increase.
  - The impact of the shock is persistent and remains larger than the average effect for up to six quarters after the shock.

### Exposure channel: banks’ holdings of public debt and consequences
- Banks hold substantial public debt, including as a share of capital, exposing them to losses on these holdings; weaker capital buffers increase banks’ default risk and alter lending behavior.
- Sample and measures:
  - Sample comprises 525 banks based in 18 emerging markets over 2000–20.
  - Median credit default swap spread in the sample is about 250 basis points.
- Key quantified effects following sovereign distress:
  - Sovereign distress defined as an explicit default or monthly average sovereign CDS spreads higher than 500 basis points within the same year.
  - Banks with a 10 percentage point higher ratio of government debt holdings to total bank assets (relative to average bank holdings) face an expected default frequency that is, on average, 0.4 percentage point higher (Figure 2.10, panel 1, green bar).
  - This effect is about twice as large for banks with relatively less capital.
  - The average expected default frequency in the sample is 1.2 percent.
- Capital and lending consequences:
  - Sovereign distress is accompanied by a decline in banks’ equity-to-assets ratio.
  - Banks with higher sovereign debt exposure cut back on lending more than peers following sovereign distress.
  - Average-capitalized banks and less-capitalized banks exhibit larger declines in equity and loans when exposed to sovereign distress (Figure 2.10, panels 2 and 4).
- Behavior during distress:
  - Banks with an average capital ratio that are more exposed further increase their holdings of government debt when the sovereign is in distress (Figure 2.10, panel 3), consistent with crowding-out effects.
- Nonlinearities and buffering:
  - Effects on default risk, bank lending, and capitalization grow in magnitude as sovereign distress deepens; the impact on banks’ equity is more than twice as large when sovereign spreads reach 1,000 basis points.
  - Sovereign holdings of international reserves act as a buffer: domestic banks in countries with a higher stock of foreign exchange reserves relative to short-term external debt experience a significantly smaller decline in capital during intense sovereign stress.
- Alternative definitions of sovereign stress examined:
  - High sovereign debt rollover needs amid significant volatility in global financial markets.
  - Sharp increase in public debt following a currency depreciation.
  - In these cases, impacts on banks’ equity and loans are significantly larger than in low-fiscal-vulnerability cases.

### Safety net channel: government support and moral hazard
- Assessment approach:
  - Uses bank-level estimates of government support called support rating floors developed by the Fitch rating agency to isolate potential sovereign support for banks.
- Main observations:
  - On average, government support proxied through support rating floors is greater in emerging markets than in advanced economies, and it has generally increased since the global financial crisis.
  - There is a strong positive relationship between bank size and government support ratings, implying large implicit subsidies for banks that are “too big to fail.”
  - Banks with higher support rating floors tend to have lower capital ratios and a majority government stake, pointing to potential moral hazard.
- Implication during sovereign stress:
  - The public safety net provides protection in normal times, but when the sovereign itself is under stress, perceived weaker ability to support banks can undermine investor confidence and bank performance.

### Figures and statistics (selected exact values preserved)
- Haircut breaching minimum CET1: about 30–40 percent.
- Minimum CET1 capital ratio referenced: 4.5 percent.
- Historical loss data sample: 68 economies during 1970–2010.
- Structural model sample: 15 emerging markets, 2006–20.
- Bank-level panel sample: 525 banks, 18 emerging markets, 2000–20.
- Median CDS spread in bank sample: about 250 basis points.
- Sovereign distress thresholds used: monthly average sovereign CDS spreads higher than 500 basis points; sovereign spreads reaching 1,000 basis points used to illustrate deeper distress.
- Effect magnitude: 10 percentage point higher bank government debt holdings → 0.4 percentage point higher expected default frequency.
- Average expected default frequency in bank sample: 1.2 percent.
- High vulnerability definitions: one standard deviation above sample average equivalent to about 80 percent (public debt) and 20 percent (bank sovereign exposure); mean values about 50 percent (public debt) and 9 percent (bank sovereign exposure).

*Source: ch2 - 4. Share of Mark-to-Market Sovereign Bonds (chapter content excerpt), IMF Global Financial Stability Report, April 2022.*

### 1. Average Bank Government Support Ratings across Emerging

### 1. Average Bank Government Support Ratings across Emerging

### Key findings on government implicit guarantees and bank outcomes
- Government implicit guarantees to the banking sector have increased since the global financial crisis.
- A support rating floor is converted to a numerical scale of 1–17 (higher values correspond to a higher rating or higher likelihood of receiving government support during distress).
- Equity returns of emerging market banks in times of sovereign distress are higher for banks whose support rating floor is one notch higher than that of their peers (Figure 2.11, panel 2), whereas in normal times there is no significant difference between the two groups.
- The positive effect of higher implicit guarantees before sovereign distress declines over time, turning negative six months after the shock.
- The negative effect on banks with high government support ratings starts sooner and is larger if the economy enters the distress event with a higher public debt burden.

### Empirical results on market reaction and bank performance
- Cumulative abnormal returns:
  - Estimated abnormal returns are computed using a capital asset pricing model-based cumulative abnormal returns associated with a one-notch-higher support rating floor after sovereign distress using a local projection methodology.
  - Sovereign distress is indicated by months with average sovereign credit default swap spreads higher than 500 basis points, a Standard & Poor’s long-term rating for sovereign foreign exchange debt that is CCC– or lower, or months with external or domestic debt defaults.
  - Estimated abnormal returns are shown for economies with a sovereign-debt-to-GDP ratio greater than 60 percent (“high public debt”) or lower than 60 percent (“low public debt”).
- Bank credit growth and capital buffers:
  - Banks with higher government support ratings experience lower credit growth, particularly after three years (Figure 2.11, panel 3, green line).
  - Banks with a higher support rating floor but lower capital expand their loan portfolios more aggressively, with cumulative credit growth about 8 percentage points higher than that of other banks two years after the distress event (Figure 2.11, panel 3).
- Nonperforming loans and risk-taking:
  - Although nonperforming loans do not seem to depend much on the level of the government support rating on average, banks with both a lower capital ratio and a higher support rating experience a significant jump in nonperforming loans in the medium term (Figure 2.11, panel 4).
- Sample and significance:
  - The sample for the banking-sector analyses is composed of 10 major emerging markets covering the period 2007–20.
  - Solid dots in figures indicate statistical significance at 10 percent or lower.

### Macroeconomic channel: sovereign downgrades to corporate and bank outcomes
- Identification strategy:
  - The analysis exploits rating-ceiling policies by comparing “bound firms” (rating equal to or above the sovereign before the downgrade) with “unbound firms” (rating lower than the sovereign).
- Effects on firms:
  - The ratings of bound firms are more affected by sovereign downgrades than the ratings of unbound firms.
  - A bound firm’s cumulative investment drops nearly 17 percentage points more than an unbound firm’s cumulative investment two years after a sovereign downgrade (Figure 2.12, panel 2).
  - The effect on investment is significantly larger if the sovereign downgrade is accompanied by higher sovereign stress, proxied by sovereign credit default swap spreads greater than 500 basis points (Figure 2.12, panel 3).
  - Low sovereign risk refers to periods with a sovereign CDS spread between 250 and 500 basis points. High sovereign risk refers to periods with a sovereign CDS spread greater than 500 basis points.
- Spillovers to banks:
  - Following a sovereign downgrade, banks’ nonperforming loans increase more in economies where bound firms play a larger role in the corporate sector.
  - A one standard deviation higher share of assets of bound firms in economy-wide corporate assets is associated with a 1 percentage point greater change in nonperforming loans two years after the sovereign downgrade (country-level difference-in-differences regression).
- Data coverage for downgrades:
  - The sample is composed of 100 sovereign debt downgrades in 29 countries during 1998–2020. Years with banking crises in which the country was downgraded are excluded for this analysis.

### Conclusion and policy recommendations
- Overall assessment:
  - The sovereign-bank nexus has intensified in emerging markets as banks’ exposure to domestic sovereign debt has increased to all-time highs while public debt is historically high and sovereign credit outlooks have deteriorated in many emerging markets.
  - A negative shock to the sovereign balance sheet could trigger an adverse feedback loop between sovereigns and banks through multiple channels, including effects on the corporate sector; this loop would be stronger in countries with higher fiscal vulnerabilities and less-well-capitalized banking systems.
- Fiscal and sovereign-debt policy:
  - Countries with stronger fiscal positions and a sound banking system should seek to extend maturities of public debt where feasible and avoid a further buildup of currency mismatches to limit balance sheet vulnerabilities.
  - In countries with limited fiscal space and tight borrowing constraints, it is imperative to:
    - improve the efficiency and targeting of fiscal spending to support recovery; and
    - embed fiscal policy in credible and sustainable medium-term fiscal plans to mitigate the impact of an adverse shock.
  - Policymakers should develop robust resolution frameworks for sovereign debt to facilitate orderly deleveraging and restructuring if needed; domestic debt restructurings may become more frequent given the increase in the share of domestic debt in total public debt in emerging markets.
- Financial sector policies:
  - Preserve banks’ resources to absorb potential losses by limiting capital distribution in cases where bank profitability is difficult to assess because of regulatory flexibility.
  - Asset quality reviews may be necessary to quantify hidden losses and identify weak banks once forbearance has ceased; results should guide supervisory actions requiring more robust levels and quality of bank capital, which could be phased in over time in a preannounced manner to minimize procyclical effects.
  - Strengthen private debt resolution frameworks in jurisdictions with inadequate corporate bankruptcy frameworks.
  - Improve transparency and data quality of banks’ holdings of government debt (by currency denomination and account classification) to assess risks arising from possible sovereign distress; market discipline will be meaningful only if disclosure becomes a necessary requirement for all banks.
  - Consider requiring banks to cover risks of significant sovereign exposures in stress tests by taking into account multiple channels of the sovereign-bank nexus.
  - When recovery permits, consider measures aimed at reducing incentives to hold excessive sovereign debt, such as:
    - nonzero, risk-sensitive capital requirements for sovereign exposures; or
    - calibrated capital surcharges on bank holdings of domestic sovereign bonds above certain thresholds that account for liquidity needs and availability of other liquid assets in domestic currency.
  - Strengthen banking crisis management frameworks (deposit guarantee programs, resolution regimes, central bank liquidity facilities) and prepare contingency plans detailing authorities’ responses to potential future pressures.
  - Ensure effective governance, regulation, and supervision of public banks; deposit-taking public banks directly competing with private banks should be subject to the same expectations and requirements of governance and prudential standards.

*Italic: Source: Chapter 2, “The Sovereign–Bank Nexus in Emerging Markets: A Risky Embrace,” Global Financial Stability Report, April 2022.*

### CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE

### CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE

### Reforms to state ownership, governance, and regulation
- Promote mechanisms to create arm’s length distance between the government as owner and bank management so banks can be run on as commercial a basis as possible.
- Separate the government’s role as an informed owner from the supervisory authority’s prudential supervision role.
- Reform agenda elements include disclosure, regulation, and supervision that place public banks on comparable footing with private banks.

### Investor diversity, market liquidity, and implications for sovereign risk
- Policymakers should promote a deep and diversified investor base to strengthen market resilience in countries with under-developed local currency bond markets (IMF 2021).
- A developed investor base should include a diverse range of bank and nonbank participants with different investment horizons and risk-return preferences, particularly institutional investors, to allow the government to spread risk in its debt portfolio and extend the yield curve.
- Domestic banks play a major role as investors in government bonds and as intermediaries for government bond trading; however, a highly concentrated banking sector can:
  - Undermine banks’ incentives to trade.
  - Impede market liquidity.
- Nonbank investors (for example, pension funds and insurance companies) generally prefer longer-dated assets and thereby facilitate the issuance of longer-dated securities and extension of the yield curve.

### Cross-country and country examples of bank sovereign holdings
- Bank holdings of sovereign debt across emerging markets range from about 5 percent of banking sector assets (examples: Chile and Peru) to more than 25 percent (examples: Brazil and Pakistan).
- In general, exposure of emerging market banks to sovereign debt has risen since the global financial crisis, most notably in China, Hungary, and Pakistan.
- Given limited country-level data availability, banks’ sovereign debt exposures for India and Argentina are computed using bank-level Fitch Connect data.

### Why banks hold government debt — identified motives
- Liquidity management: sovereign debt offers a relatively liquid asset status useful for liquidity management.
- Expected returns and limited alternative investment opportunities: attractive in countries with weaker institutions and enforcement of creditor rights that lower incentives to lend to the private sector.
- Market-making role: banks may serve as market makers in government bond markets.
- Collateral for central bank funding: government bond holdings serve as collateral for securing funding from the central bank.
- Regulatory treatment: zero risk weights on local currency domestic government bonds makes them attractive to hold.
- Moral suasion: government pressure on banks to purchase public debt.
- Risk shifting: during sovereign distress banks may increase sovereign debt exposure to take advantage of higher sovereign yields; during sovereign distress domestic banks could incur huge losses that wipe out their capital, leading to a banking crisis.

### Empirical evidence and drivers of bank sovereign exposures
- Cross-country regression results (sample of 21 emerging markets during 2000–20) show banks tend to hold more government debt when:
  - Interest rates are high.
  - The sovereign is more indebted.
  - There are fewer opportunities to lend to the private sector, as indicated by:
    - A lower ratio of stock market capitalization to GDP.
    - A lower ratio of private sector credit to GDP.
- Bank-level analysis (2011–20) findings:
  - Domestic state-owned banks purchase significantly more sovereign debt in times of high fiscal need or when the sovereign is in distress.
  - There is no evidence of government pressure on private banks.
  - Less-capitalized state-owned banks are more likely to purchase sovereign debt during periods of sovereign distress.
- Definitions and thresholds used in the analysis:
  - High fiscal need: years when maturing sovereign debt (to lagged total debt) is in the top 75th percentile of the distribution.
  - Sovereign distress: periods when the sovereign credit default spread exceeds 500 basis points, a Standard & Poor’s long-term rating for sovereign foreign currency debt CCC – or lower, or the sovereign is in external or domestic default.
  - “Less capitalized” banks: equity-to-assets ratio one standard deviation below the mean, which is about 7 percentage points.
- Interpretation:
  - The pattern of increased purchases by state-owned and less-capitalized banks during distress suggests moral suasion motives and possible risk-shifting strategies (where banks take on additional risk or seek higher yields).

### Key statistics and exact figures reported
- Bank holdings of sovereign debt examples: about 5 percent (Chile, Peru) to more than 25 percent (Brazil, Pakistan) of banking sector assets.
- State-owned banks on average held about 30 percent of total banking sector assets in major emerging markets in 2020; the ratio exceeded 40 percent in some countries.
- Regression samples and periods: cross-country regression sample of 21 emerging markets during 2000–20; bank-level cross-country regression during 2011–20.
- Sovereign distress threshold: sovereign credit default spread exceeds 500 basis points.
- “Less capitalized” threshold: equity-to-assets ratio about 7 percentage points (one standard deviation below the mean).
- High fiscal need cutoff: top 75th percentile of maturing sovereign debt (to lagged total debt) distribution.

*Source: CHAPTER 2 ThE SOvEREIGN-BANk NExUS IN EMERGING MARkETS: A RISkY EMBRACE (IMF, April 2022)*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2022/april/english/ch2.pdf_