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1 December 2014 CFA Institute Journal Review

Sovereign Default, Domestic Banks, and Financial Institutions (Digest Summary)

  1. Servaas Houben, CFA

Using a blend of mathematics and data analysis, the authors reveal that government defaults are costly for countries because of the significant impact on local banks. They show that there is a close link between a government’s default averseness and its ability to borrow from banks. Strong financial institutions provide government discipline for repaying because the consequence of not repaying is material.

What’s Inside?

Recent research indicates that the main costs of a government default are borne by the domestic banking sector, which may explain the relative infrequency of defaults. Banking losses result in a downfall of the rest of the economy, which happened in Russia. The authors develop a theoretical framework based on a three-period decision model in which the players are the government, banks, and local or foreign residents. Based on their model, they derive guidelines that they use in their empirical analysis.

How Is This Research Useful to Practitioners?

When governments can default only on particular debts—for example, foreign-held debt—it is possible for them to shield domestic banks. This perfect discrimination scenario is difficult to implement in practice because the trading of public bonds occurs. Thus, the authors suggest looking at an imperfect discrimination scenario.

They show that domestic banks use government debt to store liquidity to finance future investments. When the government decides on a default, it is trading off of domestic banks’ wealth in exchange for extra domestic resources. The authors also show that better-developed financial institutions allow for more leverage in banks and attract foreign capital. In contrast to other researchers, the authors also take into account the default impact on financial intermediaries.

They demonstrate, based on data analysis, that private credit declines more for countries in which banks hold more public debt, which supports the assumption of nondiscriminatory defaults. Furthermore, credit declines are higher in countries with strong financial institutions and more foreign capital, and these countries face a lower probability of default.

Banks hold fewer government bonds in countries with high creditor rights, and defaults have a greater impact in countries with better financial institutions and where banks hold more government bonds.

This research would be especially interesting for investment professionals looking into credit and default risk, especially in an international environment.

How Did the Authors Conduct This Research?

The authors develop a two-time horizon economy with several players in which public bonds face default risk and private deposits encounter court enforcements. In the model, residents allocate their wealth either to banks in the form of deposits or to an investment project. The government then decides which part of public debt is repaid.

Based on their model, the authors derive some conclusions. For example, increased investor protection allows banks to become more leveraged. Public bonds work in a pro-cyclical manner; banks require more liquidity when investment opportunities are available. The model is applied in both a closed economy (without foreign investors) and an open economy (with foreign investors). In the open economy, residents can borrow in excess of their endowment from international markets and capital outflow is possible. The authors show that foreign capital increases leverage, which results in a stronger reduction of credit when default occurs.

They then apply the International Monetary Fund and World Bank datasets from 1980 to 2005 in their empirical analysis. To measure the size of domestic credit markets, they choose the change in the ratio of private credit to GDP. They define default as either (1) the failure of the government to pay interest or principal payments or (2) debt rescheduling. The creditor rights index is used to model the quality of a country’s financial institutions. It also incorporates creditor debt-collection ability.

The authors conclude that defaults have become shorter over time. Furthermore, defaults tend to occur with banking crises and vice versa, and a default is usually followed by a worsening of local credit markets. Interestingly, although there is no direct link between public debt and reserve requirements, banks often invest in bonds in excess of reserve requirements.

Abstractor’s Viewpoint

After the 2008 economic crisis, there was an increased focus on government default behavior and the relationship between banks and the government. Public debate has since focused on bankers’ remuneration and on the structure of banks—for example, by the creation of barriers between savings banks and investment banks. The question of which sectional interests the government should favor during a bailout has been less discussed, and the authors clearly state the different trade-offs a government faces in these situations. The setup of the article is clear, and the theoretical framework is followed by an empirical analysis.

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