The Banking Exposure to International Lending: Regional Differences or Common Fundamentals?

The present study unveils the importance of regional characteristics of sovereign debt crises in Latin America and South East Asia. It proposes and empirically corroborates a refinement of the logit approach, for assessing sovereign risk, which draws upon a region‐specific parameterization—composite estimator. The analysis identifies some common features of debt crises that largely reflect domestic solvency, liquidity factors and, to a lesser extent, trade‐balance variables and external shocks. Nonetheless, heterogeneity effects and regional signals point towards the use of region‐specific models. Such approach depicts specific risk factors such as openness and debt burden for Latin America and reserves, output and government expenditure for Asia, thereby suggesting distinctive aspects to debt crises. Out‐of‐sample forecast comparisons further support the use of the composite estimator. The latter outperforms the simple pooled and random effects approach on the basis of various criteria, albeit slightly biased towards false non‐crises predictions.     

Sovereign liquidity crises: Analytics and implications for public policy

This paper offers an analytical framework with which to assess some recent proposals for strengthening the international financial architecture. We develop a model of sovereign liquidity crises that reflects two sources of financial stress – weak fundamentals and self-fulfilling expectations. We examine the nature of the underlying co-ordination game and investigate the properties of the unique equilibrium. In so doing, we are able to characterise the welfare costs of belief-driven crises, which we find to be potentially significant. We also evaluate some recent policy proposals including prudent debt and liquidity management, capital controls, greater information disclosure, and the efficacy of monetary policy tightening in the midst of crisis.     

Macroeconomic imbalances,financial stress and fiscal vulnerability in the euro area before the debt crises: A market view

This paper tries to identify the macro-financial imbalances that exposed the euro area countries to fiscal stress before the outbreak of the European debt crises. Contrary to conventional wisdom that interprets fiscal stress in terms of fiscal sustainability, we focus on short-term fiscal vulnerability as reflected by the conditions of debt refinancing in the sovereign bond markets. We find that market-based indicators capturing risk perceptions of sovereign debts have been influenced by the indicators defined in the European Macroeconomic Imbalance Procedure (MIP) and by variables of financial vulnerability. When pricing the risk of sovereign bonds, the holders of government debts take into account not only the macroeconomic imbalances but also factors such as banking distress, corporate bond risk, liquidity risks in the interbank market or the volatility of stock prices.     

Collateral Framework: Liquidity Premia and Multiple Equilibria

Central banks normally accept debt of their own governments as collateral in liquidity operations without reservations. This gives rise to a valuable liquidity premium that reduces the cost of government finance. The ECB is an interesting exception in this respect. It relies on external assessments of the creditworthiness of its member states, such as credit ratings, to determine eligibility and the haircut it imposes on such debt. We show how such features in a central bank's collateral framework can give rise to cliff effects and multiple equilibria in bond yields and increase the vulnerability of governments to external shocks. This policy can potentially induce sovereign debt crises and defaults that would not otherwise occur. The success of the ECB's temporary suspension of these features of its collateral framework during the pandemic illustrates the practical relevance of this mechanism.     

Sovereign Debt Crises in Latin America: A Market Pressure Approach

ABSTRACT

We construct a continuous sovereign debt crisis index for four large Latin American countries for the period 1870?2012. To obtain the optimal set of indicators and the optimal value of the threshold for dating crises we apply the receiver operating characteristic (ROC) curve. Our sovereign debt crisis index is a weighted average of three indicators: the debt-to-GDP ratio, the external interest rate spread, and the exports-to-imports ratio. The continuous index allows a more advanced analysis of sovereign debt crises as illustrated with an investigation of the relationship between sovereign debt crises and business cycles in Latin America.     

Governance and bank characteristics in the credit and sovereign debt crises – the impact of CEO power

The global financial sector recently suffered from two interrelated crises: the credit crisis and the sovereign debt crisis. A common question is whether the recent experience with the credit crisis has helped in dealing with the sovereign debt crisis. We study more specifically whether banks with powerful CEOs perform better or worse than other banks, and if there is any difference in this relationship between the two crises. Using unique hand-collected data for 378 large global banks, we find that CEO power has a significant positive relation to bank profitability and asset quality, but also to insolvency risk, during the sovereign debt crisis. Thus, strong CEOs do not appear to be detrimental to bank performance. Our results also support the idea that deposit insurance may have contributed to the credit crisis.     

Presidential Address: Debt and Money: Financial Constraints and Sovereign Finance

Economic analyses of corporate finance, money, and sovereign debt are largely considered separately. I introduce a novel corporate finance framing of sovereign finance based on the analogy between fiat liabilities for sovereigns and equity for corporations. The analysis focuses on financial constraints at the country level, making explicit the trade‐offs involved in relying on domestic versus foreign‐currency debt to finance investments or government expenditures. This framing provides new insights into issues ranging from the costs and benefits of inflation, optimal foreign exchange reserves, and sovereign debt restructuring.     

Sovereign debt ratings and stock liquidity around the World

This paper studies the impact of sovereign debt rating changes on liquidity for stocks from 40 countries for the period 1990–2009. We find that sovereign rating changes significantly affect stock liquidity. The impact is stronger for downgrades than for upgrades, and is nonlinear in event size. The loss of investment grade has a particularly strong negative impact on stock liquidity. We also find that some stock characteristics and country legal and macroeconomic environment are important in explaining the differences in the impact of sovereign credit rating changes on stock liquidity across countries.     

Long and short-runs determinants of the sovereign CDS spread in emerging countries

In this paper, we study the long and short-runs determinants of sovereign CDS spread for eight emerging countries from 2008.Q4 to 2013.Q2. We estimate the spread of sovereign CDS using three macroeconomic determinants: current account, external debt and international reserves. Using the Pooled Mean Group cointegration approach, our findings can be summarized as follows: i, the existence of cointegration between the variables indicated above; ii, the coefficients of the current account, the external debt and international reserves are highly significant to explain the long-run sovereign CDS spread for all countries; iii, international reserves are more important than the current account in order to reduce the sovereign CDS spread in long-run; iv, when allowing for heterogeneous short-run dynamics, the short-run effects are not significant for all countries.     

Sovereign collateral as a Trojan Horse: Why do we need an LCR+

Sovereign bonds are widely used as collateral in banks’ funding and trading operations. If a sovereign becomes distressed, the collateral mechanism impairs and banks are suddenly facing significant liquidity calls. Basel III's Liquidity Coverage Ratio (LCR) protects banks against unexpected liquidity calls, but currently excludes sovereign distress. Thus, all banks fulfilling the LCR are still exposed to a liquidity risk stemming from distressed sovereign debt and materializing through the collateral channel. Our paper shows that this unaddressed risk can translate into a system-wide liquidity shock. To gauge the potential damage caused by such a shock, we develop a model based on banks’ home sovereign exposures and a bundle of simplifying assumptions in which sovereign distress triggers bank distress. Our model describes how deteriorating sovereign collateral can lead to an overall liquidity squeeze and non-compliance with Basel III liquidity standards. As this risk is too material to be neglected, we propose an alternative version of the LCR, LCR+, which includes the liquidity impact of sovereign distress.     

Financial crises and political crises

The simultaneous determination of financial default and political crises is studied in an open economy model. Political crises accompany default in equilibrium because of an information transmission conflict between the government and the public. Multiple equilibria are possible: if foreign lenders are pessimistic about the country's stability, they demand a high interest on the debt, exacerbating distortions and possibly leading to political crisis; but if lenders are optimistic, the cost of the debt falls and political crises disappear. In such a case, international liquidity packages can select the best equilibrium and rule out political crises at negligible cost.     

The insolvent state: analyzing organized procedures for restructuring the bankrupt sovereign

The purpose of this Article is to examine the impetus behind the movement for a sovereign bankruptcy procedure. The intention is to look at what has (and has not) been said on this issue and evaluate the soundness of various proposals. Part II of this Article looks at the background of international debt crises and the underlying discussions that have taken place on this issue in the international arena. Part III looks at more recent thinking on the subject, sheds light on Argentina's catastrophic global debt crises, and discusses the statutory and market‐oriented solutions for sovereign debt crises. Part IV concludes that the way forward, for now, is to include majority action provision in bond contracts while encouraging responsible internal governance for sovereigns. Such an approach is beneficial until the international market revisits an overarching proposal. Copyright © 2007 John Wiley & Sons, Ltd.     

Rating the rating agencies: Anticipating currency crises or debt crises?

We revisit the question whether sovereign ratings predict financial crises. In line with previous studies, we find that ratings do not predict currency crises and are instead downgraded ex-post. However, the likelihood of currency crisis and the implied probability of sovereign default are not closely linked in emerging markets post-1994. When debt crises are defined as sovereign distress – when spreads are higher than 1000 basis points or 10 percentage points – we find that access to international capital markets is reduced by half. In addition, although sovereign distress events last for typically 5.2 consecutive months, they can persist for longer periods up to nine quarters. Finally, lagged ratings and ratings changes, including negative outlooks and credit watches, are useful in anticipating sovereign distress.     

Mandatory Disclosure,Voluntary Disclosure,and Stock Market Liquidity: Evidence from the EU Bank Stress Tests

We use the EU stress tests and the Eurozone sovereign debt crisis to study the consequences of supervisory disclosure of banks’ sovereign risk exposures. We test the idea that a mandatory one‐time disclosure induces an increase in voluntary disclosures about sovereign risk in the following periods and, through the shift in the voluntary disclosure equilibrium, increases the liquidity of banks’ shares. First, we find that the timing and content of different mandatory disclosure events helps explain the levels of stress‐test banks’ voluntary disclosures about sovereign risk. Second, although the bid‐ask spreads of stress test participants generally increased after the mandatory stress test in 2011, our results suggest that the decrease in market liquidity is entirely attributable to those stress‐test participants that did not commit to voluntarily maintaining the disclosures of sovereign risk exposure.     

Sovereign CDS Spreads,Volatility, and Liquidity: Evidence from 2010 German Short Sale Ban

The paper examines global impact of 2010 German short sale ban on sovereign credit default swap (CDS) spreads, volatility, and liquidity across 54 countries. We find that CDS spreads continue rising after the ban in the debt crisis region, which suggests that the short selling ban is incapable of suppressing soaring borrowing costs in these countries. However, we find that the ban helps stabilize the CDS market by reducing CDS volatility. The reduction in CDS volatility is greater in the eurozone than that in the non‐eurozone. Furthermore, we find that the CDS market liquidity has been impaired during the ban for the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) countries. In contrast, there are no dramatic changes in the market liquidity for non‐PIIGS eurozone and non‐eurozone samples. The findings suggest that the short sale ban is ineffective to reduce sovereign borrowing costs in the debt crisis region if the underlying economy has not been significantly improved.     

Sovereign debt disputes: A database on government coerciveness during debt crises

This paper measures “debt disputes” between governments and foreign private creditors in periods of sovereign debt crises. We construct an index of government coerciveness, consisting of 9 objective sub-indicators. Each of these sub-indicators captures unilateral government actions imposed on foreign banks and bondholders. The results provide the first systematic account of debt crises that goes beyond a binary categorization of default versus non-default. Overall, government behavior and rhetoric show a strong variability, ranging from highly confrontational to very smooth crisis resolution processes. In a preliminary analysis on the determinants of coercive behavior, we find political institutions to be significant, while economic and financial factors play a lesser role. These results open up an agenda for future research.     

Crises, Volatility, and Growth

How do volatility and liquidity crises affect growth? When creditis constrained, a bias toward short-term debt can arise in financinglong-term investments, generating maturity mismatches and leadingpotentially to liquidity crises. The frequency of liquiditycrises ("abnormal" volatility) and the volatility of growth("normal" volatility) are found to have independent negativeeffects on growth. Financial development however dampens thegrowth cost of volatility, but only in the case of normal volatility.The growth cost of volatility therefore depends critically onthe composition of normal and abnormal volatility, the latterbeing more costly for growth.     

Exchange Rate Crises and Fiscal Solvency

This paper combines insights from generation one currency crisis models and the fiscal theory of the price level (FTPL) to create a dynamic FTPL model of currency crises. The initial fixed‐exchange‐rate policy entails risks due to an upper bound on government debt and stochastic surplus shocks. Agents refuse to lend into a position for which the value of debt exceeds the present value of expected future surpluses. Policy switching, usually combined with currency depreciation, restores fiscal solvency and lending. This model can explain a wide variety of crises, including those involving sovereign default. We illustrate by explaining the crisis in Argentina (2001).     

Collateral haircuts and bond yields in the European government bond markets

Analyzing a novel collateral haircut dataset, this paper investigates the relations between the collateral haircuts and the yields of Euro-area central government bonds. The empirical analysis shows that investors demand higher yields for bonds with higher collateral haircuts. The importance of collateral haircuts on bond yields remains robust after controlling for the variations in credit quality, market liquidity and the effects of the European sovereign debt crisis.