The Impact of Sovereign Credit Risk on Bank Funding Conditions

From the Committee on the Global Financial System [BIS]

Sovereign credit risk is currently a significant issue for European banks and over coming years may have implications for global financial stability.

This report examines the relationship between sovereign credit risk and bank funding conditions, how banks might respond to an environment of ongoing elevated sovereign risk and the implications for policy makers. It was prepared by a Study Group chaired by Fabio Panetta from the Bank of Italy.

The report concludes that increases in sovereign credit risk push up the cost and weaken the composition of banks’ funding, and that banks cannot fully insulate themselves by adjusting their operations. As a consequence, the official sector has a key role in minimising the impact of weaker public finance conditions on banks, but there are trade-offs. First and foremost, governments need to maintain sound public finance conditions. Bank supervisors should also closely monitor the interaction of sovereign risk with regulatory policies that encourage banks to hold large quantities of public debt. Central banks might also consider having flexible collateral frameworks that, during severe crises, allow funding to be supplied against a broad range of collateral, but this is not costless, and hence should be used sparingly and with appropriate safeguards in place.

Related:
Speech by Jaime Caruana, General Manager of the BIS.

Recent events underscore the lesson that financial stability depends not only on the links between banks and the corporate and household sectors, but also on those between banks and the sovereign. The sovereign must be prepared to act as ultimate backstop for the financial system. But this requires that fiscal buffers be built up in good times. Otherwise, the sovereign can itself become a source of financial instability, as its credit risk interacts in a malign way with bank and other private sector credit risks. Sovereigns must now earn back their reputation as borrowers that are practically risk-free. Ultimately, the sovereign’s solvency is a precondition for the central bank’s success in dealing with threats to monetary and financial stability.

Evolution of Rating Distribution of Sovereign Issuers on Selected Dates

Source: Moody’s Sovereign Default and Recovery Rates,1983-2010

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