With The Economist and others now forecasting a post-Covid sovereign debt crisis, Junye Li, Professor of Finance at ESSEC Business School, Asia-Pacific, demystifies the connection between bank credit risk and sovereign risk through his research and analysis of the previous crunch.

How Much of Bank Credit is Sovereign Risk? by CoBS Editor Nicolas Desarnauts. Related research: How much of bank credit risk is sovereign risk? Evidence from Europe, Junye Li, Gabriele Zinna: Journal of Money, Credit and Banking, Vol. 50, No. 6.

Erupting in 2009, the European sovereign debt crisis exposed the tight nexus between banks and sovereigns. As system-wide rescue packages were introduced, European banks’ exposure to sovereign risk became apparent. However, it is still unclear what drives investors’ perception of a bank’s overall sovereign exposure. Through his analysis of the crisis, Professor Junye Li of ESSEC Business School demystifies the connection between bank credit risk and sovereign risk, providing valuable insights for investors and regulators alike.

Sovereign Risk: Europe’s crisis

Sovereign risk can be defined as the risk of investing or lending in a country arising from possible changes to the business environment and the failure of the country to meet or refusal to honour its sovereign debt payments. As the 2008 financial crisis froze capital markets around the globe, several European countries that had maintained large structural budget deficits through cheap borrowing were suddenly unable to finance their expenditures.

This triggered the European sovereign debt crisis. Greece, Portugal, Ireland, and Spain were among several Eurozone countries that were unable to repay or refinance their government debt. They were also unable to rescue the over-indebted banks that were under their national supervision. Fiscally-sound countries like Germany that were capable of repaying their debts were nonetheless affected by the crisis as the shared euro currency and integrated financial sector enabled contamination across the Eurozone. And this caused systematic sovereign risk that threatened the entire Eurozone economy.

As such, in a concerted effort, other Eurozone countries, the European Central Bank, and International Monetary Fund provided assistance to the most distressed European countries. This effectively brought an end to the European sovereign debt crisis, although endemic problems endure.

Risky exposure

While the European crisis centred around state finances, it exposed the tight nexus between banks and sovereigns as credit risks extended beyond the public sphere. In his paper, Prof. Li explains that banks are both directly and indirectly exposed to sovereign risk.

Most evidently, ownership of sovereign debt in the form of government bonds on their balance sheets represents a direct risk for banks. If countries become unable or unwilling to repay their sovereign debts, banks that hold that debt will be under financial strain.

However, Prof. Li emphasizes that this is not the only way sovereign risk can translate into bank risk. Banks, he argues, are also indirectly exposed to sovereign risk “through a number of channels, ranging from risky bank business models to the dwindling value of the sovereign guarantee”. Moreover, as in the case of the European sovereign debt crisis, sovereigns can either default in isolation due to country-specific credit shocks or in conjunction with other countries due to common credit shocks.

As a result, banks are exposed to both sovereign “country risk” from individual countries like Spain and sovereign “systematic risk” from the amalgamation of country risk in unions like the Eurozone.

To uncover how much of bank credit risk can be attributed to the various forms of sovereign risk, Professor Li conducted a study analyzing the European sovereign debt crisis. Indeed, as deteriorating fiscal conditions destabilized the continent’s banking system, European banks’ exposure to sovereign risk became increasingly apparent. This made Europe “the natural laboratory” to empirically examine the connection between bank credit risk and sovereign risk.

Prof. Li used the market for Credit Default Swaps (CDS)—a financial instrument used to hedge against the risk of debt repayment—to measure banks’ exposure to sovereign risk. His sample covered 12 European countries and 54 banks over the period from January 2008 to December 2015. The systematic and country-specific aspects of sovereign risk were separated using a multivariable statistical model and further analysis provided an estimation of banks’ respective sovereign and non-sovereign risk. Professor Li’s findings provided surprising new evidence of the extent of risk exposure and the “bank-sovereign nexus”.

Sovereign Risk: Indirect over direct

Professor Li finds that sovereign credit risk accounts for an average 35% of European banks’ credit risk. However, the share of bank credit risk caused by sovereign risk varies over time and across banks.

At the onset of the global financial crisis in 2008, bank credit risk was largely nonsovereign. Only soon after the collapse of the Lehman Brothers and the consequent introduction of system-wide stabilisation efforts, the systematic-sovereign risk emerged, accounting for an increasing share of bank credit risk. Thereafter, following assurances made by Mario Draghi—president of the European Central Bank—in his 2012 “Whatever it Takes” speech, systematic risk wore off.

Nevertheless, a significant fraction of bank credit risk remained sovereign but was driven by country-specific risk. Here, Professor Li highlights a difference between non-vulnerable and vulnerable countries: while systematic risk is the main source of sovereign risk for banks in non-vulnerable countries like the United Kingdom, country-specific risk supersedes it in vulnerable countries like Italy. Moreover, investors perceive sovereign risk as short-term in non-vulnerable countries and long-term in vulnerable countries.

Most surprisingly, for both non-vulnerable and vulnerable countries, Professor Li finds that banks’ exposure to sovereign risk is mostly indirect. Indeed, while there is a “positive and monotonic relationship between the bank holding of European sovereign debt and the estimated total bank-sovereign exposure,” indirect factors such as “expected government support” are more consequential.

Professor Li finds that banks that expect more government support are more closely linked to the fortunes of the domestic economy. Therefore, they are more likely to default in the event of a country-specific sovereign credit shock. Direct exposure, in contrast, turns out to be less important and usually irrelevant to bank credit risk when bank size is controlled for. In Professor Li’s words, “put simply, bank direct sovereign risk exposures seem to offer only a limited picture of the overall exposure of a bank to sovereign risk, as perceived by the investors”.

Breaking the bank-sovereign nexus

Professor Li’s analysis contributes to the ongoing policy debate about the drivers of bank exposures to sovereign risk and adequate measures to break the tight bank-sovereign link. His findings suggest that the market perceives bank direct sovereign exposures as a relevant, but not as the main driver of banks’ sovereign credit risk. Indeed, the indirect exposures of banks to sovereign risk appear to be particularly important. As such, measures designed to address, for example, the “too-big-to-fail” conception, more than those aimed at limiting banks’ sovereign debt holdings, should prove more effective in breaking the bank–sovereign nexus.

Useful links:

• View Prof. Junye Li’s academic profile
• Discover ESSEC Business School Asia-Pacific, Singapore
• Learn about the full-time ESSEC Master in Finance programme on the Singapore campus
• Read a related feature: The What and Why of Sustainable Finance

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