Sovereigns and Financial Intermediaries Spillovers

IMF Working Papers, February 27, 2019

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The paper examines spillover effects between sovereigns and banks in a model with a heterogeneous banking system.
An increase in sovereign’s default risk affects financial intermediaries through two channels:
- Banks’ funding costs might increase, inducing higher interest rates on loans and bonds and a cut back in these assets.
- A financial regulator’s risk-weighted asset framework would assign higher weights to lower quality assets, implying a portfolio rebalancing and more deleveraging.
Capital adequacy requirements have a dual role:
- They weaken the impact of shocks emerging from the real economy.
- They amplify the effect of shocks on banks’ balance sheets.

Heterogeneous banking system underpinning the analysis.
Two primary transmission channels from sovereign risk to banks:
- Funding-cost channel: higher funding costs → higher interest rates on loans and bonds → contraction in these asset holdings.
- Regulatory risk-weight channel: lower quality assets receive higher risk weights → portfolio rebalancing and deleveraging.
Interaction between regulatory capital frameworks and shock origins:
- Real-economy shocks: capital adequacy requirements mitigate effects.
- Balance-sheet shocks (e.g., sovereign downgrades): capital adequacy requirements amplify balance-sheet pressures.

Regulatory design matters for how sovereign shocks propagate to banking systems:
- Risk-weighted asset frameworks can induce procyclical portfolio adjustments when sovereign risk rises.
- Capital adequacy requirements can be stabilizing for real-side disturbances but destabilizing for direct balance-sheet shocks tied to sovereign risk.
Monitoring and managing sovereign-bank linkages is essential given the two distinct transmission channels identified.

Subject: Bank credit, Bank deposits, Banking, Financial institutions, Financial services, Labor, Loans, Money, Self-employment, Sovereign bonds
Keywords: balance sheet identity, bank capital, Bank credit, Bank deposits, banking sector, Contagion, deposit bank, Europe, Global, hiterbank market, interest rate, lending bank, leverage ratio, Loans, Northern Europe, Self-employment, Southern Europe, Sovereign bonds, Sovereign risk, sovereigns-banks nexus, wholesale bank, WP

By Hamid R Tabarraei, Abdelaziz Rouabah, and Olivier Pierrard. February 27, 2019.