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The Zero Risk Fallacy? Banks' Sovereign Exposure and Sovereign Risk Spillovers
... This was the case for Greek banks that lost more than 30 billion euros when the Private Sector Involvement program initiated in 2012 led to a haircut of 53.5% of the face value of the Greek bonds held. zero-risk weights to the sovereign debt issued by any EU member country (see Kirschenmann et al. (2017) for the regulatory treatment of sovereign bond holdings in the EU). Therefore, holdings of domestic sovereign bonds may be more attractive for banks since they make capital requirements easier to meet. ...
... Becker and Ivashina (2017) also find that government ownership and government influence through banks' boards of directors are positively related to Eurozone banks' bias for domestic sovereign debt. Kirschenmann et al. (2017) argue that a sovereign-bank feedback loop can also emerge in safe countries that belong to a group of financially integrated economies. They describe a subtle mechanism whereby banks in safe countries buy non-domestic sovereign bonds issued by riskier countries in the same group. ...
... The empirical results in our particular setting show that regulatory standards do not seem to significantly impact home bias. However, our empirical analysis does not test for the indirect effects caused by regulatory standards, such as those described by Kirschenmann et al. (2017). ...
In this paper, we examine the determinants of bank holdings of domestic sovereign debt with a panel dataset of 295 banks in 35 countries between 2002 and 2013. The findings indicate that the structure of bank ownership (domestic, foreign, or government ownership), the quality of governance, and the level of financial development of the countries in which banks operate all determine the level of home bias. Specifically, we find that domestic banks tend to hold more domestic sovereign debt relative to their foreign counterparts. We also provide evidence that home bias is even stronger when the domestic bank is controlled by its government. Moreover, home bias increases when government bonds are more risky, home governments are less effective, and when banking systems are less financially developed. Overall, we find that banks’ home bias in holding sovereign debt is an international phenomenon that is determined by both bank- and country-specific factors.
... On one hand, a large number of researchers has concentrated on identifying sources of systemic risk(e.g. Brunnermeier, 2009;Georg 2013; Hellwig, 2009;Breckenfelder and Schwaab, 2017;Kirschenmann et al., 2017). On the other hand, the recent regulatory frameworks from many countries and regions are on the look for mechanisms which could allow them to mitigate the systemic risk in the most effective way.The academic literature on bank interventions has been mostly focused on assessing the intervention mechanisms from a bank or country perspective rather than from a multi-country,systemic context. ...
This thesis presents a collection of essays into bank performance and stability. The introduction provides an overview of the topic as well as the broader context behind the subsequent chapters. The first chapter focuses on empirical investigation into factors determining performance of investments of a multinational development bank. I construct a unique database of almost 1,600 EBRD investments. It is a first study of all EBRD investments which complements the literature on the project performance of MDBs. My findings suggest that the probability of project success is higher with larger investments and projects under framework. Also, projects with state clients are less likely to be successful. I address the selection bias and this further contributes to the related literature. The second chapter is a cross-bank, cross-country and cross-time empirical study of bank performance in the context of government interventions into failing banks during financial crises. I use a novel database consisting of banks which received government intervention and their non-intervened peers in 39 countries between 1990 and 2017. The findings contribute to the latest empirical literature which is far from conclusive by identifying no clear winner among the studied interventions with gains as well as potential losses under each intervention. I argue that a ‘one-size-fits-all’ intervention approach is suboptimal. The final chapter of my thesis looks at the bank performance analysis in the context of financial stability. I apply the model of financial stability by Goodhart et al. (2004, 2005) to illustrate the impact of government interventions on banks’ behaviour using data for UK banks. The model has been widely used by central bankers and regulators to illustrate the trade-offs between bank’s performance and financial stability. This is its first application in the context of government interventions. The final chapter concludes my thesis.
... Our higher-level research goal is to see whether the new regulatory framework could turn out to be effective during the next financial crisis that is now emerging as an outcome of the Covid-19 pandemic. Brunnermeier, 2009;Georg 2013;Hellwig, 2009;Breckenfelder and Schwaab, 2017;Kirschenmann et al., 2017). However, limited attention has been paid to the investigation of potential tools to mitigate a contagious effect when systemic risk is already present in the market. ...
We study the effectiveness of three common bank resolution mechanisms: bailouts, bank sales, and ‘bad banks’. We first apply the financial fragility model of Goodhart et al. (2005, 2006a) to analyze the impact of these resolution mechanisms on bank behavior. We then use a novel bank-level database on 39 countries that used these resolution mechanisms during 1992-2017 and analyze the relationship between the mechanisms applied and subsequent bank performance. We find that the effectiveness of resolution mechanisms depends crucially on the timing and severity of crises. While mergers can deliver good results at the beginning of a crisis, this is less likely at later stages of a crisis. In the event of severe crises, mechanisms aimed at restructuring bank balance sheets are most likely to deliver positive results. We find no support for bank bailouts as an optimal strategy. A calibration exercise shows that the effectiveness of resolution mechanisms to mitigate systemic risk declines with the severity of crises.
... This, of course includes almost all European bonds, and scholars and regulators agree that most banks are thus treating European debt as risk free. 6 In order to get a proxy of how capital ratios of large European banks would change if EBA guidelines were implemented, we use the standardized approach/ the formal ratings approach based on calculations by Kirschenmann, Korte, and Steffen (2016), using data from EBA transparency exercises. Specifically, we use the latest release of the dataset by the European Banking Authority including 88 banks across Europe. ...
This study examines whether the purchase of sovereign bonds leads to decreased bank risk and how this impact changes in worse macroeconomic conditions. For a broad picture of macroeconomic shocks, we concentrate on the dimensions of uncertainty (the cross‐sectional dispersion of shocks to bank‐level characteristics) and crises (the global financial crisis and the COVID‐19 contagion). An empirical examination of the Vietnamese banking sector between 2007 and 2021 shows that banks purchasing securities issued by the domestic government tend to have lower risk. However, this impact is relatively weak on average, varying with the measures of bank risk. Through subsample tests, we document that the impact of sovereign bond holdings on bank risk is shaped by banks with high‐risk‐weighted assets and low diversification. Further results designate that sovereign bond holdings are necessary for banks as such activities help significantly lower their risk exposure in periods of crisis and uncertainty. This finding remains robust to different measures of bank risk.
La preocupación por la retroalimentación entre riesgos bancarios y soberanos
ha estado presente desde el inicio de la crisis, y de hecho se intensificó en los primeros años de la misma, al hilo del aumento de las tenencias de deuda pública
por parte de las entidades de crédito, especialmente en los países más sometidos
a estrés, entre ellos el nuestro. El debate se centraba en el tratamiento regulatorio
dado a dichas tenencias de deuda pública, y en particular si el mismo podría estar
incorporando comportamientos por parte de las entidades financieras (excesiva
inversión en deuda pública del propio país) que contribuyesen a amplificar el círculo
vicioso entre riesgos bancarios y riesgos soberanos.
This paper examines the relationship between sovereign credit ratings and bank stability in Central America and the Caribbean (CAC). We use data on 177 banks from 24 countries for the period 1999–2014 and find that sovereign rating downgrades precede deterioration in bank stability. The finding highlights the importance of understanding the transmission channels and the amplification of sovereign risk spill-overs. With respect to the former, we found evidence to support both the “balance sheet exposure” and “asset valuation adjustments” arguments found in the literature. Concerning the latter, the sovereign risk spill-overs are more intense in countries with low foreign currency reserves, limited financial transparency and weak central bank independence. Our findings support the argument that banks are vulnerable to the aggravation of sovereign risk concerns and thus, the zero risk weight to sovereigns should be reviewed.
We document the mechanism through which the risk of fire sales in the sovereign bond market contributed to the effectiveness of two major central bank interventions designed to restore financial stability during the European sovereign debt crisis. As a lender of last resort via the long‐term refinancing operations (LTROs), the European Central Bank (ECB) improved the collateral value of sovereign bonds of peripheral countries. This resulted in an elevated concentration of these bonds in the portfolios of domestic banks, increasing fire‐sale risk and making both banks and sovereign bonds riskier. In contrast, the ECB's announcement of being a potential buyer of last resort via the Outright Monetary Transaction (OMT) program attracted new investors and reduced fire‐sale risk in the sovereign bond market.
We analyze government interventions in the eurozone banking sector during the 2008–2009 financial crisis. Using a novel data set, we document that fiscally constrained governments “kicked the can down the road” by providing banks with guarantees instead of fully-fledged recapitalizations. We econometrically address the endogeneity associated with bailout decisions in identifying their consequences. We find that forbearance prompted undercapitalized banks to shift their assets from loans to risky sovereign debt and engage in zombie lending, resulting in weaker credit supply, elevated risk in the banking sector, and, eventually, a greater reliance on liquidity support from the European Central Bank.
Recent policy discussion includes the introduction of diversification requirements for sovereign bond portfolios of European banks. In this paper, we evaluate the possible effects of these constraints on risk and diversification in the sovereign bond portfolios of the major European banks. First, we capture the dependence structure of European countries' sovereign risks and identify the common factors driving European sovereign CDS spreads by means of an independent component analysis. We then analyze the risk and diversification in the sovereign bond portfolios of the largest European banks and discuss the role of "home bias", i.e., the tendency of banks to concentrate their sovereign bond holdings in their domicile country. Finally, we evaluate the effect of diversification requirements on the tail risk of sovereign bond portfolios and quantify the system-wide losses in the presence of fire-sales. Under our assumptions about how banks respond to the new requirements, demanding that banks modify their holdings to increase their portfolio diversification may mitigate fire-sale externalities, but may be ineffective in reducing portfolio risk, including tail risk.
We study spillovers from bank to sovereign risk in the euro area using difference specifications around the European Central Bank's release of stress test results for 130 significant banks on October 26, 2014. We document that following this information release bank equity prices in stressed countries declined. Surprisingly, bank risk in stressed countries was not absorbed by their sovereigns but spilled over to non-stressed euro area sovereigns. As a result, in non-stressed countries, the co-movement between sovereign and bank risk increased. This suggests that market participants perceived that bank risk is shared within the euro area.
The empirical literature regarding financial institution interconnectedness and potential systemic risk has burgeoned in the last decade. Broad conclusions from this research pertaining to credit default swaps (“CDSs”) include the following: (i) Single-name CDSs on corporate, banking, and sovereign reference entities are a source of interconnectedness and contain information that may be valuable to policy makers in measuring potential systemic risk, but there is a dearth of empirical evidence to indicate that single-name CDSs are systemically destabilizing; (ii) single-name sovereign CDSs are transmission mechanisms for economic shocks but not generally a cause of those shocks; and (iii) a “sovereign-bank” loop integrates the financial condition of the banking sector with sovereign credit risks.
We examine European banks' exposures to systematic and country‐specific sovereign risk. We organize our investigation around a multifactor affine credit risk model estimated on credit default swap data of different maturities. During the 2008–15 period, about one third of banks' credit risk is sovereign. However, banks strongly differ both in the magnitude and type of their sovereign exposures. Measures of indirect exposures, such as bank size and return on equity, capture these cross‐sectional differences better than measures of direct exposures. Furthermore, the properties of the distress risk premiums turn out to be important to understand the effect of sovereign risk on bank funding costs.
We provide a survey on the literature examining financial market fragmentation in the euro area and discuss the policy options how to reduce it. The fragmentation has increased markedly since the outbreak of the global financial crisis in 2007. It declined somewhat from late 2012 onwards, but is still above the pre-crisis level. Interest rate pass-through has become less efficient primarily because of increased mark-ups and, to a certain extent, the lower responsiveness of bank interest rates to policy rates. The effectiveness of interest rate pass-through has become more heterogeneous across euro area countries, making a common monetary policy more difficult. The unconventional monetary policy conducted by the European Central Bank has reduced financial market fragmentation notably; however, this policy was not without side effects. Enhancing financial and fiscal stability in the euro area is key for the efficient functioning of the monetary transmission mechanism.
Bank’s exposure values are classified by categories on the basis of the borrower or the kind of credit. On every credit a risk weight is applied depending on the risk of the exposure value. The exposure value multiplied by risk weight determines the weighted asset of the bank. This amount determines the regulatory capital a bank needs since the total capital ratio of a bank is defined as the ratio of regulatory capital over the weighted asset. The paper examines the evolution and structure of the exposure values considering the risk weighting of the systemic Greek banks during the crisis period. Due to mergers and acquisitions, these banks cover more than 98% of the Greek banking market by the end of 2016. The paper offers an analysis on a consolidated basis but also through a comparative analysis investigates similarities and differences existing within those banks and during the crisis period. Thus the paper can conclude on the policy followed by banks during the crisis period.
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