Sovereign Debt Crisis - Example

SОVЕRЕIGN DЕBT СRISIS Name Course Tutor University Department Introduction The Euro sovereign debt crisis began due to combination of factors; the global financial crisis and sovereign debt developed in various EU countries like Spain, Greece, Ireland, and Portugal in late 2009. Consequently, a crisis of confidence in debt instruments was issued by these countries. In early 2010, it caused shock in the global market was extremely rapid due to the euro area strong integrated financial systems and trade. However, the crisis was more severe in Greece and threatened other countries economy in the Eurozone. The European Union has worked with International Monetary Fund to resolve the debt crisis, as well as to restore the market confidence in Eurozone. For example, some of the fiscal trouble countries such as Greece, Portugal, and Ireland have been rescued. Nevertheless, the Eurozone sovereign debt continued to threaten financial market in the first half of 2011. The primary reason for the need to stabilize the situation was the assumption that it would result in a financial contagion and spread to other member states in the euro area making the debt crisis to become even more complicated. The crisis also sent the shock through the global banking system, calling for government and central banks interventions. During this period, the banks had accumulated large holding of sovereign debt, particularly from countries with large sovereign debt outstanding (Berger & Bouwman 2013). As the crisis became severe, Greece restructured their debt, and thus triggered losses on the lending bank balance sheet. We are going to analyze, how the crisis affected bank lending, the policy adopted, and the challenges faced by the regulators. Impacts of the sovereign debt crisis on banks' exposure The crisis that erupted in 2010 has affected the banking system calling for government and central bank intervention. European authorities have promised to donate 1 trillion euros for recapitalization purposes (Chrysoloras 2015). The central bank made short-term loans of significant amount to the members of the euro banking system as a way of mitigating the impacts of deteriorating sovereign debt on banking sector balance sheet. They argued that if no measures were taken, the crisis would be the most instantaneous threat to global economy. The government debt securities are usually held by the banks on their balance sheet. The primary reason for this is because of the capital directive that allows the Basel Accords to a 0% risk weight to be assigned to the government bonds. Banks offer special privileges to government debt that is given using the euro currency compared to other asset holdings. This privilege only applies to debt issued in euros. However, European banks hold a sizeable amount of debt issued by the foreign sovereign. This also includes debt issued by the GIIPS countries, that is, Spain, Italy, Ireland and Portugal. Meanwhile, the deterioration in the sovereign creditworthiness affected the financial sector and lending to the private sectors in the GIIPS countries reduced. Consequently, there was an increase in borrowing uncertainty for private sectors on whether it would be easier to access bank funding in future. Theoretically, there are two ways in which sovereign debt held on bank increased risk can result in an adverse effect on the bank balance sheet, and thus credit supply. First, sovereign debt losses have a negative impact on the bank profitability because it affects the asset side of the balance sheet. Furthermore, the anticipated sovereign bond losses may raise concerns about counterparty risk. As Gertler & Kiyotaki (2010) argues that this increased riskiness of the bank will have a direct negative impact on funding cost and availability. For instance, after the European sovereign debt crisis, the market counterparties such as US mutual funds market became more concerned about the anticipated risks of lending to banks that were sovereign debt exposures. Secondly, in most cases the sovereign debt is used by banks as collateral to secure its overall funding. Therefore, the increased riskiness of sovereign debt minimizes the collateral eligibility, and thus the banks funding capability. Figure 1: Multi-bank lending Source. (Popov & Neeltje 2013) Figure 1 shows multi-banks lending between 2007 and 2011. The figure shows that lending by the EU banks was not distinct compared to other global syndicated lending. Figure 2: Impact of debt of bank credit. Source (Popov & Neeltje 2013) Figure 2 shows that there was no significant rate changes between the two multi-bank lenders. However, when the crisis deepened, Greek acquired a bailout loan, and thus lending for affected has been lower than non-affected banks. It is clear that there is a relationship between lending by banks and the weakening of sovereign debt creditworthiness. Figure 2 shows that there was an increased lending of affected bank after the third quarter of 2010 than non-affected banks. Policy Implications There are two strategies that have been employed the beginning of the crisis to reverse the slowdown in bank lending as a result of deteriorating sovereign debt. They are asset and liquidity operations by the European Central Bank, as well as pubic finances combined with loans from IMF and EU in the affected countries. According to Berger & Bouwman (2013), the role of European Central Bank since the crisis began has been imperative, and at the same time within the framework of monetary policy strategy. ECB uses monetary pillars that emphasis on the significance of a long term relationship prices and money. This involves monitoring monetary sums to assess the effectiveness of the economic policies that direct daily making and execution of monetary policy. The economic pillar is predicted by price stability and policy interest rates. The economic stability can be achieved through price stability by central banks changing the interest rates bringing it to potential targets. ECB also organized open market operations to ensure that the entire unsecured interbank rate monitors its policy. The concept of market intervention is based on the assumption that effective financial markets should link all the asset prices and interest rates through arbitrage. More importantly, interest rate pathway is crucial, and thus, if the central banks predict both current and future short-term interest rates through signaling, as well as market interventions, it will enable it to influence interest rate path. Therefore, asset prices and interest rates will move to emulate policy intentions price and demand stability, consumer consumption, and investment. Additionally, the intervention of consolidated public finances has also been employed to stabilize the Eurozone. The European Union announced in 2012 its Outright Monetary Transactions (OMT) programme that pledged support of Eurozone member in need of financial assistance with the purchase of country's government bonds on secondary markets. As a result, confidence was restored in the euro area, and the government bond yields of the Eurozone members was reduced, and thereby decreasing borrowing costs. However, this intervention has increased the risk of moral hazard. Thus, EU should protect public debt and deficit levels of the members’ countries under stress, both in the short-term and in the long-term. However, the usefulness of reducing government bond markets tensions is highly debated; ECB intervention has been regarded to be effective. In other words, the ECB policy of asset purchases has stabilized slowdown in lending and thus allowing the bank to reduce exposure due to the deteriorating sovereign debt. Challenges and Responses faced regulators The European Central Bank has faced numerous challenges because of the significance of finance in the start and development of the crisis. Moreover, the monetary policy is flexible and a powerful economic instrument. ECB faced a lot of challenges because the crisis started during the establishment of the European monetary integration project. The deployment of monetary policy to solve the current crisis was limited. For instance, the crisis composed of transfer of income between countries, in which the monetary policy has no authority (Gertler & Kiyotaki 2010). In other words, when the risk factors are beyond its scope, it will be difficult for other economic components to act. This means that ECB is answerable to the 17 sovereign states in their parliaments. ECB therefore, cannot undertake any operation that involves income transfers between member states without acceptance of the parliaments. ECB cannot assume the function of income transfer, as this would result in conflict of monetary policy. As a result, ECB had to address the issue of financial fragmentation and sustainability of monetary integration. These issues were vital to euro area economic and monetary policy. The ECB non-standard measures that were adopted to meet the huge liquidity a primary concern of reducing the risk of fragmentation of the euro area. The tension forced ECB to announce the outright monetary transactions (OMT) programme. It was necessary to make changes in the area of monetary policy to overcome the crisis. Currently, the monetary policy has no mandate to resolve the problems underlying the euro crisis, and thus, it is clear that ECBs unresponsiveness would have resulted in a catastrophe. Under the circumstances, the ECBs measures to preserve the euro single currency and restore monetary transmission was necessary to achieve monetary stability. The challenges faced, thus justified the inclusion of OMT programme that sees the possibility of purchasing a sovereign bond of the member state speculated they may abandon the euro. Moreover, despite benevolent economic conditions, many countries in the euro area already had a deficit record even before the crisis. They had failed to consolidate sufficiently public finance in time, and hence, there was room to absorb the fiscal burden as a result of the debt crisis. The overreliance on side demand expansion intensified the downturn in these countries during the crisis. The debt crisis in Greece spread to Spain, Italy, Portugal and Belgium because rating changes could affect others. To counter this, Greece agreed with IMF and the European Commission to give a bailout loan. However, use of a consolidated public finance with EU and IMF loans is also faced with higher risks of moral hazard, particularly risk of delaying necessary measures. Conclusion The sovereign debt crisis has forced many governments to re-evaluate their budgets. The close relationship between banks and sovereign resulted in financial instability by increasing threat that affects both sectors. A country must strive to maintain a fiscal position, but a crisis will have an adverse impact. Consequently, bank conditions worsen due to an increase in negative effect on their balance sheet. In the case of Euro crisis, they implemented several methods, asset and liquidity operations by the European Central Bank and finances combined with loans from IMF and EU in the affected countries to reverse the slowdown in bank lending. Given the challenges for fiscal policy, central banks should prepare for a more severe period of sovereign risk premia. Banks should also control the interaction of regulatory policies and sovereign risks that allow banks to hold large quantities of public debt. References List Berger, A. N., & Bouwman, C 2013, ‘How does capital affect bank performance during financial crises?' Journal of Financial Economics, vol. 109, no. 1, pp. 146-176. Chrysoloras, N 2015, 'Emergency Liquidity Assistance for Greek Banks: Explainer'. Bloomberg Business week, Viewed 16 December 2015, Gertler, M., & Kiyotaki, N 2010, 'Financial Intermediation and Credit Policy in Business Cycle Analysis' in Friedman, B, and M Woodford (eds.), Handbook of Monetary Economics, Elsevier: Amsterdam, Netherlands. Popov, A., & Neeltje, H 2013, 'The impact of sovereign-debt exposure on bank lending: Evidence from the European debt crisis', Vox, Viewed 16 December 2015, Read More