Impact of the Sovereign Debt Crisis on Bank Credit Risk Exposures and Implications for Policymakers - Essay Example

Student Name: Tutor: Title: Sovereign Debt Crisis Course: Executive summary The sovereign debt crisis had serious implications in various economic sectors of the affected countries. This paper traces the background of the sovereign debt crisis in Eurozone and its aftermath. The introduction gives a brief preview into the subject matter and sets the tone for the discussion. The first part digs into the important issue concerning the origin of the sovereign debt crisis in the EU. It highlights the negligence by the EU officials that led to stringent provisions being overlooked in favour of numbers to galvanize the region. The second part looks at the impact of the crisis on banks’ credit risk exposures and the general impact in the banking sector across the region. The final part discusses implications for policy makers both within the region and globally in the attempt to deal with the consequences of the crisis. The conclusion echoes important points about the sovereign debt crises and its implication to the financial sector, the regional and the world as a whole. Introduction The impact on the sovereign debt crisis on the ability to access bank funding was critical in capital provision. Domestic and regional capital markets were affected. The European debt crisis spread steadily through Europe and its effects were felt far and wide. The real estate and the banking sector were adversely affected. Some banks collapsed as depositors saw their hard-earned savings go down the drain. Banks’ exposures were mostly to the home sovereign. The higher sovereign risk reduced the value of the collateral banks are able to use to raise wholesale funding as well as central bank liquidity (Arteta & Hale, 2008). The consequences of this channel were only contained by central banks’ intervention. This paper traces the origin of the sovereign debt crisis in the EU and its impact on banks’ credit risk exposures. It further discusses the widely implications of the sovereign debt crisis regionally and globally. a. The background to the recent sovereign debt crisis in the EU. Majority of analysis’s trace the source of the European sovereign debt crisis to 5th of November in the year 2009 when it was revealed that the budget deficit of Greece was 12.7% of the Gross Domestic Product (GDP). This was more twice more than what the country had previously divulged. The origins of the debt crisis can be further be traced to the structures which govern institutions in Europe and the players in charge of European institutions’ governance. The emergence of the European Union as best known today came about after the ratification of the Maastricht Treaty in 1992 (Arteta & Hale, 2008). The provisions within the treaty put in place very stringent economic requirements that were referred to as convergence criteria. Member states were obligated to meet these provisions being gaining admission to the common currency zone that has been referred to as Eurozone. These provisions, however, were not followed and applied keenly in practice hence resulting into future problems. There was no was little due diligence enforced when evaluating suitability for admitting nations into the Eurozone. The agility of the officials to build a competitive and vast Eurozone made them to gloat over some of the warning signs (Davies, 2011). The Maastricht treaty did not, however, provide enforcement mechanisms in case member states failed to comply with the convergence criteria. Admission into the Eurozone promised huge economic rewards as states whose credit ratings appeared was lower as compared to strongest member states would borrow money if the attained superior ratings. The common currency had the promise of being able to prevent trading partners not to devalue their currency hence compelling all the Eurozone members to compete on a playing field that was leveled. The euro came into being in 2002 as a currency among European Union member states hence consolidating the largest trading unit in the world while creating a strong currency. The impact of the negligence was not felt immediately. States at the periphery thrived initially after being propelled by accessibility to unprecedented credit from other Eurozone member states. After the global financial meltdown of 2007-8, the liquidity dried up bringing to forth huge public debts as well as unsustainable deficits (Schnabl, 2012). By the year 2010 sovereign debt crises, significantly pronounced in Greece, had widely spread throughout the periphery. By the year 2011 the IMF and EU had bailed out Ireland, Greece, and Portugal. Figure 1: Yields within Europe Prior to the financial crisis some governments within the Eurozone like Spain, Greece, Ireland, Portugal and Italy were able to finance their deficits at artificially lower interest rates. Some ended up accumulating unsustainable levels of public debts. The reckless fiscal behavior went on unabated since markets had the assumption that if national situations grew worse, the governments would be bailed out by other nations within the EU block in order to prevent breaking up of the euro (Khwaja & Mian, 2008). Consequently governments overindulged in debt. b. Impact of the sovereign debt crisis on banks’ credit risk exposures The sovereign debt crisis send ripples throughout the banking system and compelled interventions by central banks and governments on a level that can be related to programs implemented in the course if financial crisis in 2008-09. Countries in the Eurozone periphery slipped into a critical sovereign debt crisis (Arezki, Candelon & Sy, 2011). Beginning with Greece in 2009, the financial crisis spread to Portugal, Ireland, Spain and Italy. These nations underwent critical economic downturns resulting into high fiscal debts, lower tax revenues and unpredictable surge in sovereign credit risk. The deterioration in the creditworthiness sovereignty fed back into the financial sector for two main reasons. Firstly, banks possess huge domestic government bond holdings. For instance, by mid-2011 the domestic sovereign bonds; holdings of two main Italian banks (Intesa and UniCredit) amounted to 175 and 121 percent of their core capital respectively. The same fate befell Spanish banks (Angeloni & Wolff, 2012). Secondly, banks suffer from collateral damage owing to the weakening of the implicit bailout guarantees. Bank lending contracted significantly following the sovereign debt crisis. The credit crunch prompts sharp increase within the uncertainty of borrowing firms as whether they are able to obtain bank funding in the near future (Acharya &Steffen, 2012). The decline in loan supply prompted increase in the uncertainty for borrowing firms since they were not sure of accessing bank funding in future. Higher sovereign risk from the end of 2009 pushed the cost of bank funding as well as negatively impacted on the composition of some euro area banks’ funding. Banks in some acutely affected countries were unable to raise wholesale debt as well as deposits and relied heavily on the central bank liquidity. Increase in the wholesale funding cost spilled over to other banks that are located in other European countries although with less effects (Cetorelli & Goldberg, 2011). The banks retained access to funding markets. Major advanced economies’ banks experienced only little changes within their wholesale funding costs. In some countries the sovereign public finances were the initial origin of the fragility then was spread into banks. Regardless of the source of the crisis, exposure of banks in Europe to credit risk of the domestic sovereign was apparent since the end of 2008. Banks are further exposed to credit risk within the non-domestic sovereigns (Khwaja & Mian, 2008). The public debt sustainability within European countries in the periphery hinders the health of both the domestic banking sector and further the banking sectors of Eurozone countries. Whereas financial institutions have often needed to content with market risk on sovereign debt owing to interest rate expectations that are changing, the sovereign credit risk as well as its implications pose an urgent and significant challenge to banks all over. The challenges become acute when the bank’s home sovereign is in distress. Cyprus’s hugely unbalanced banking sector collapsed by early 2013 as foreign capital fled and much of the financial sector was left insolvent (Bofondi, Carpinelli, & Sette, 2012). The 2012 cuts taken by private holders of Greek debt accentuated the panic since banks from Cyprus held majority of the devalued Greek bonds. By March 2013 Cyprus obtained a $13 billion bailout that compelled the largest bank in the country to close shop inflicting heavy losses to some of the wealthiest depositors in the country. c. Wider implications for policy makers within the region and globally The sovereign debt crisis within Europe persists to weigh heavily on political systems and credit markets across the developed world. The financial crisis as well as the subsequent economic downturn has put a lot of pressure on public finances in some of the advanced economies in the world. Fiscal deficits have hugely grown demonstrating the impacts of automatic stabilizers, official sector aid to the financial sector, and discretionary stimulus measures. It is reported from the end of 2007 and the end of 2010 the mean budget deficits within the OECD countries grew from one prevent to eight percent of the GDP as well as the gross government debt widened from 73 percent to 97 percent of the GDP (Arezki, Candelon & Sy, 2011). Sovereign debt pressure has been acute within the Eurozone. Portugal, Ireland and Greece obtained international official aid because they were unable to obtain funding devoid of raising unsustainably high interest rates. More nations have witnessed their debt spreads grow substantially due to investor concerns regarding the fiscal conditions. By the end of 2011 the debt crisis spread to larger countries including Italy which is the third largest economy in in the Eurozone. A bailout was not an option for Italy considering its over $2.6 trillion public debt. The Italian Prime Minister Silvio Berlusconi was compelled to step aside and a new government led by Mario Monti was put in place (Cetorelli & Goldberg, 2011). The new government had a clear mandate of effecting budget cuts and reforms within the labor markets and pensions. Just like Ireland, Spain experienced a housing-market bust that made the banking sector to be highly exposed. The country requested for a bailout in 2012 and the EU leaders were in agreement to give the Spanish government $123 million for the purpose of recapitalizing its struggling banks (Schnabl, 2012). By the year 2014 periphery countries except Cyprus and Greece had finalized their bailout programs. Ireland was the first nation to exit its program in December of 2013. The government debt levels in many advanced economies are expected to persistently rise in the following years owing to high fiscal deficits as well as rising healthcare and pension costs. The level of the economic output that is important to the capacity of debt servicing is unlikely to go back to its pre-crisis trend in the near future. Sovereign risk premia can be consistently higher and more volatile in future. Almost all Eurozone members have debt levels that exceed the convergence criteria maximum set at 60%. This category consists of huge economies like France (89.4%), Spain (70.2%), Italy (121.4%), and Germany (81.9%). Figure 2: Composition of banks' liabilities in Ireland, Greece and Portugal Consequently the sovereign debt crisis can be referred to as a Europe crisis and not just a problem that the Greeks have to solve by themselves. Many structural problems continue to go on unabated including weak banking systems, high unemployment levels, as well as rigid labour markets. Youth unemployment in the Eurozone stands at 23% hence threatening to result into a lost generation (Cetorelli & Goldberg, 2011). Austerity measures were employed in some of the affected countries to try and deal with the consequences of the sovereign debt crisis. There is an array of issues that are unresolved by the European leadership before the crisis ends. Conclusion The insincerity of some member states like Greece in disclosing their public debt levels and negligence by EU officials saw the sovereign debt crisis spread to the Eurozone and its ripple effects felts regionally and globally. The sovereign debt crises had serious implications on the European Union member states. It compelled bailout plans to be extended to some of the members who were hugely in debt. The banking sector was both a trigger and a casualty in the crises. Holding huge government bonds by some banks led to depositors losing their money when the credit crunch begun to hit. The intervention by central banks and governments was not enough to prevent some banks from closing shop. Investors decried the slow pace of government to foresee the problem and look for the way forward. The crisis led to a recession in many sectors as people cut panicked and cut down on their spending. The implications of the sovereign debt crisis were enough both regionally and globally. References Acharya, V., & Steffen, S., 2012. The Greatest Carry Trade Ever? Understanding Eurozone Bank Risks, NYU working paper. Angeloni, C., & Wolff, G. 2012. Are Banks Affected by Their Holdings of Government Debt? Bruegel Working Paper No. 07. Arezki, R., Candelon, B., & Sy, A.2011. Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis. IMF Working Paper No. 68. Arteta, C., & Hale, G. 2008. Sovereign Debt Crises and Credit to the Private Sector, Journal of International Economics 74, 53–69. Bofondi, M., Carpinelli, L., & Sette, E., 2012. Credit Supply during a Sovereign Crisis, Bank of Italy mimeo. Cetorelli, N., & Goldberg, L., 2011. Global Banks and International Shock Transmission: Evidence from the Crisis. IMF Economic Review 59, 41–76. Davies, M., 2011, The rise of sovereign credit risk: implications for financial stability, BIS Quarterly Review, September 2011, pp. 59-70 Khwaja, A., & Mian, A., 2008. Tracing the Impact of Bank Liquidity Shocks: Evidence from an Emerging Market, American Economic Review 98, 1413-1442. Schnabl, P., 2012. Financial Globalization and the Transmission of Bank Liquidity Shocks: Evidence from an Emerging Market, Journal of Finance 67, 897-932. Read More