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© 2022 International Monetary Fund
WP/22/223
IMF Working Paper
Monetary and Capital Markets Department
The Sovereign-Bank Nexus in Emerging Markets in the Wake of the COVID-19 Pandemic
Prepared by Andrea Deghi, Salih Fendoglu, Tara Iyer, Hamid Reza Tabarraei, Yizhi Xu, and Mustafa Yasin Yenice*
Authorized for distribution by Mahvash Qureshi
November 2022
IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
ABSTRACT: The COVID-19 pandemic has brought the relationship between sovereigns and banks—the so-called sovereign-bank nexus—in emerging market economies to the fore as bank holdings of domestic sovereign debt have surged. This paper examines the empirical relevance of this nexus to assess how it could amplify macro-financial stability risks. The findings show that an increase in sovereign credit risk can adversely affect banks’ balance sheets and credit supply, especially in countries with less-well-capitalized banking systems. Sovereign distress can also impact banks indirectly through the nonfinancial corporate sector by constraining their funding and reducing their capital expenditure. Notably, the effects on banks and corporates are strongly nonlinear in the size of the sovereign distress.
| JEL Classification Numbers: | E44, F34, F65, G21 |
| Keywords: | Sovereign-bank nexus, emerging markets, financial stability, sovereign risk, COVID-19, banking sector, corporate investment |
| Author’s E-Mail Address: | ADeghi@imf.org; SFendoglu@imf.org; HTabarraei@imf.org; TIyer@imf.org; YXu@imf.org; MYenice@imf.org |
| JEL Classification Numbers: | E44, F34, F65, G21 |
| Keywords: | Sovereign-bank nexus, emerging markets, financial stability, sovereign risk, COVID-19, banking sector, corporate investment |
| Author’s E-Mail Address: | ADeghi@imf.org; SFendoglu@imf.org; HTabarraei@imf.org; TIyer@imf.org; YXu@imf.org; MYenice@imf.org |
Title Page
WORKING PAPERS
The Sovereign-Bank Nexus in Emerging Markets in the Wake of the COVID-19 Pandemic
Prepared by Andrea Deghi, Salih Fendoglu, Tara Iyer, Hamid Reza Tabarraei, Yizhi Xu, and Mustafa Yasin Yenice
Contents
I. INTRODUCTION
II. CONCEPTUAL FRAMEWORK
III. DEVELOPMENTS IN THE SOVEREIGN-BANK NEXUS IN EMERGING MARKETS: SOME STYLIZED FACTS
IV. EVALUATING THE STRENGTH OF THE NEXUS
V. AN EMPIRICAL EVALUATION OF THE TRANSMISSION MECHANISMS
A. Sovereign Exposure Channel
B. Safety Net Channel
C. Macroeconomic Channel
VI. CONCLUSIONS
REFERENCES
FIGURES
Figure 1 Key Channels of the Sovereign-Bank Adverse Feedback Loop
Figure 2. Developments in Emerging Market Public Debt and Banks’ Sovereign Exposures
Figure 3. Transmission of Risks through the Sovereign-Bank Nexus: Strength of the Main Channels across
Emerging Markets
Figure 4. Transmission of Sovereign Risk through the Exposure Channel
Figure 5. Stylized Facts on Bank Support Rating Floor in Emerging Markets
Figure 6. The Effect of Safety Nets on Banks’ Returns following Sovereign Distress in EMs
Figure 7. Additional Robustness Analysis on the Effect of Safety Net on Banks’ Returns
Figure 8. Banks’ Risk-Taking and Moral Hazard during Sovereign Distress
Figure 9. Sovereign Downgrades and Bound vs. Unbound Firms in Emerging Markets
Figure 10. Sovereign Downgrades Impact on Bound vs. Unbound Firms in EMs
Figure All. 1 The Impact of a Tightening of Global Financial Conditions on Sovereign and Bank
Figure AIM. 1 Moral Suasion and Risk Shifting: Threshold Effects
TABLES
Table 1. Exposure Channel: The Effect of Sovereign Distress on Bank Equity at Different Distress Thresholds
Table 2. Exposure Channel: Valuation Effect on Fiscal Debt and Key Bank Outcome Variables
Table 3. Exposure Channel: The effect of debt rollover risks on key bank outcome variables
Table 4. Safety Net Channel: The Effect on Banks’ Equity Abnormal Returns
Table 5: Safety Net Channel: The Effect on Banks’ Risk-Taking Activity
Table 6. Macroeconomic Channel: Baseline Regressions. Change in investment ratio and debt
Table 7. Macroeconomic Channel: Corporate Investment Following a Sovereign Downgrade at
Table 8. Macroeconomic Channel: Placebo Tests Baseline Regressions
Table 9: Macroeconomic Channel: Indirect Impact of Sovereign Downgrade on Banks through Firms
Table A.I.1 List of Countries in the Emerging Markets Sample
Table A.I.2. Sovereign Stress/Default Episodes Coverage
Table A.I.3. Data Description and Sources
Table A.I.4 Summary Statistics
Table A.II.1. Number of daily changes in volatility regimes
Table A.III.1. Regression Results for the Drivers of Bank’s Sovereign Debt Holdings
ANNEXES
Annex I. Data Description and Summary Statistics
Annex II. Structural Model Estimation and Model Extensions
Annex III. Examining the Presence of Moral Suasion and Risk-Shifting
The authors are very grateful for comments by Viral Acharya, Tobias Adrian, Fabio Natalucci, Mahvash Qureshi, Jérôme Vandenbussche and seminar participants at the International Monetary Fund, the Association of Supervisors of Banks of the Americas (ASBA), Central Bank of Colombia, Yale Financial Stability Program, The Hong Kong Monetary Authority, The Monetary Authority of Singapore, and The Joint Vienna Institute. Oksana Khadarina and Dmitry Yakovlev provided outstanding research assistance.