By Dr. Simon Cottrell, Finance Lecturer and the Research Degree Coordinator for Finance and Property, University of South Australia’s Business School
One of the global pandemic’s most visible economic and monetary ramifications was the swift escalation of borrowing across nations to meet their domestic monetary needs. Despite prolonged economic constraints, governments and central banks took decisive measures to maintain livelihoods through fiscal funding and liquidity initiatives. In response to the COVID-19 pandemic, many governments opted to lift spending caps, directing funds toward essential services and supporting struggling sectors of the economy. Consequently, this led to substantial budget deficits and, in certain cases, unsustainable debt levels.
For instance, the United States federal government borrowed a staggering $2.8 trillion to fund emergency fiscal-spending programs in 2020. Presently, the overall sovereign-debt level in the US stands at approximately US$32 trillion, with projections suggesting a further increase of $12 trillion over the next decade. In other Western economies, government-debt issuances at comparable levels have contributed to elevated debt-to-GDP (gross domestic product) ratios (see Table 1). These developments have significant implications for the global economic landscape and call for careful consideration in navigating the path toward fiscal recovery and sustainable monetary practices.
Indeed, during times of crisis, borrowing is commonly viewed as a reasonable approach that does not necessarily lead to disastrous consequences. However, escalating levels of sovereign debt cause significant concern. The approach to the US debt-ceiling impasse earlier this year was a recent instance exemplifying this concern. These critical events have significant ramifications for the country’s financial stability and global economic confidence. The debt ceiling is a statutory limit on the total amount of debt that the US government can accumulate, and when this limit is reached, it triggers a series of high-stakes negotiations in Congress to raise the ceiling. Failure to reach an agreement before the deadline could lead to severe consequences, such as a potential default on U.S. Treasury obligations.
The uncertainty surrounding these deadlines creates significant turmoil in financial markets, particularly impacting US sovereign credit default swaps (SCDS). These financial instruments act as insurance contracts against the risk of a sovereign default. When debt-ceiling deadlines loom and the likelihood of default increases, investors become more apprehensive about holding US government debt and other financial assets directly impacted by increased levels of default risk. Consequently, demand for credit default swaps (CDS) surges, leading to rising prices and higher costs for investors seeking to hedge against the potential default risk.
This motivates an investigation into the spillover effects of US sovereign default risk on global interbank funding markets.
The literature presents empirical evidence of sovereign-debt crises and economic recessions having been correlated with higher levels of SCDS spreads, implying an influence on financial markets in general. For instance, Farinha et al. (2019)1 analyzed the effects of bank shocks after a sovereign-debt crisis, finding that rises in sovereign credit issuances have driven bank-funding difficulties in a given credit crunch. Specifically, they found that banks experiencing negative funding shocks significantly reduced credit to borrowing firms. Related work by Czech (2021)2 found an influence between SCDS and global corporate bond markets. Miranda‐Agrippino and Rey (2020)3 showed that the tightening of US monetary policy has been followed by considerable levels of deleveraging of global financial intermediaries, rises in aggregate risk aversion, contractions in global asset prices, declines in global credit, widenings of corporate bond spreads and retrenchments of gross capital flows.
Avino and Cotter (2014)4 analyzed the relationship between sovereign and bank CDS spreads in six major European economies. Their main findings suggest that during crisis periods, SCDS spreads are more efficient in pricing European banks’ default risks than using the CDS spreads of the respective banks’ debt instruments, thereby providing earlier signals of the default risk of a country’s banking system. Grammatikos and Vermeulen (2012)5 found that following the collapse of Lehman Brothers in 2008, financial pricing in the European Union (EU) became more dependent on changes in Greek SCDS spreads than in the period leading up to the Lehman crash.
The most recent and contrasting addition to the debate is presented by Calomiris et al. (2022)6. Their study focused on US data from the Great Depression, aiming to investigate whether interbank relationships played a pivotal role in contagion during the crisis. Specifically, they examined interbank market activities to determine whether contagion spread through these relationships, leading to significant bank distress during the Great Depression. Their findings revealed that contractual connections among banks impacted liquidity risks. Moreover, they discovered that interest-rate risk could act as a transmission channel for default risk.
This research expands the existing literature by investigating whether US sovereign default risk exerts a more significant influence than home-country sovereign default risk on interbank default risk.
We used equivalent country interbank Libor-OIS spreads as proxies for domestic interbank default risks and CDS spreads on sovereign bonds as proxies for sovereign default risks. The Libor-OIS spread refers to the difference between the London Interbank Offered Rate (Libor) and the Overnight Indexed Swap (OIS) rate. Libor represents the interest rate at which banks lend to one another in the London money market, while the OIS rate reflects the market’s expectations of the central bank’s overnight interest rate.
This spread is essential because it provides insights into the perceived credit risk and liquidity conditions in the interbank lending market. A wider spread suggests that banks are more hesitant to lend to each other, indicating tighter liquidity in the financial system. On the other hand, a narrower spread indicates improved confidence in financial markets and smoother interbank lending conditions.
During times of financial instability, the Libor-OIS spread tends to widen as banks become more cautious about lending and may face difficulties in securing short-term funds.
This study aimed to assess the influence of US sovereign default risk as a driving factor of domestic interbank default risk compared to the impact of domestic sovereign default risk in five Libor countries, including Canada and Australia. This was accomplished by first examining whether US sovereign credit default swaps (SCDS) play a pivotal role in influencing equivalent-currency-based Libor-OIS spreads on a global scale. Secondly, the study investigated whether US SCDS are more significant determinants of Libor-OIS spreads than the equivalent home-country SCDS. In particular, the research explored whether US SCDS retain statistical significance in driving Libor-OIS spreads even after accounting for control variables commonly implied in the existing literature. We included Australia and Canada in our analysis since their banking systems are the most reliant on bank wholesale funding globally, particularly offshore funding, and hence are particularly sensitive to importing foreign sovereign default risk (see Table 2).
Note: This table shows the financial institutions’ wholesale funding ratios, expressed as liabilities (total liabilities including equity less derivatives and other non-debt liabilities) to total assets, across different countries.
Our research findings contribute valuable insights into the subject in several key ways. Firstly, our analysis, based on pooled OLS (ordinary least squares) regression, reveals a noteworthy positive relationship between domestic SCDS and the Libor-OIS spread of the respective country at a significant level of 1 percent. However, it is worth noting that the influence of SCDS seems to primarily capture time variance, as the significance diminishes when time-fixed effects are considered.
Specifically, the analysis indicates that the impacts of US sovereign credit default swaps extend beyond its borders, revealing positive relationships with the Libor-OIS spreads in countries outside the US. Additionally, when comparing the SCDS spread of the US with those of other countries against their respective Libor-OIS spreads, our robust results reveal a notably greater magnitude of the US SCDS spread.
Furthermore, our research highlights the heterogeneous nature of sovereign credit spread impacts across different countries. For instance, on an individual-country basis, we observe significant relationships between US SCDS and the Libor-OIS spreads of the eurozone, Canada, Japan and Australia. Intriguingly, the coefficients of home-country SCDS are not found to be significant.
Delving deeper, we notice distinct patterns in the United Kingdom and Switzerland. In the case of the United Kingdom, home-country SCDS play a significant role in driving interbank funding risks, while US SCDS are deemed insignificant. On the other hand, neither US SCDS nor Swiss SCDS seem to influence the equivalent Libor-OIS spreads in Switzerland significantly.
In conclusion, this research explains the complex relationships between sovereign credit default swaps and interbank funding markets, uncovering interesting variations in the impacts across countries. These findings offer valuable insights for policymakers and financial institutions seeking to navigate the intricate dynamics of wholesale funding markets.
The influence of the US banking system’s sovereign default risk extends globally, significantly impacting the wholesale funding costs borne by banks worldwide. As a result, spillover effects from US sovereign-debt markets impact international financial markets. That is, in countries such as Japan, eurozone members and Australia, bank wholesale funding costs are driven not by their respective domestic sovereign default risks but instead by the sovereign default risk prevailing in the US. Consequently, many prominent financial institutions with large debt-funding liabilities effectively “import” US sovereign default risk, creating yet another potential source of contagion and spillover effects between the US and foreign financial markets.
The findings here should be of great importance to regulators and monetary-policy authorities. By way of example, for a Japan-based bank, any expansionary monetary-policy decision made by the BOJ (Bank of Japan) may be offset by an increase in US sovereign default risk, hence obviating any real benefits of such accommodative monetary policy from the BOJ. For fund-management companies with investment holdings in wholesale debt securities from the countries impacted by US sovereign default risk, these results are particularly interesting in relation to bond-portfolio risk-management strategies.
The implications of this research could extend further, particularly considering the requirements of the Basel III capital framework developed by the Basel Committee on Banking Supervision (BCBS). Specifically, these reforms require banks to raise additional longer-term wholesale funding to bolster their short-term funding activities, as stipulated by the net stable funding ratio (NSFR) and total loss-absorbing capacity (TLAC), which may result in banks paying higher costs for funding instruments depending on the level of sovereign default risk in the respective country where the funding originated. Another policy reform that may transmit sovereign default risk onto banks’ balance sheets includes banks having to hold high-quality liquid assets (HQLA). Specifically, the HQLA requirements specify that a bank must hold a certain amount of government bonds as part of its risk-weighted regulatory capital. One possible consequence of this policy reform could be the emergence of what is known as “wrong-way risk”, especially if a substantial amount of default risk is factored into the sovereign bonds a bank holds as part of its HQLA requirements.
1 Journal of Financial Intermediation: “Bank shocks and firm performance: New evidence from the sovereign debt crisis,” Luisa Farinha, Marina-Eliza Spaliara and Serafeim Tsoukas, October 2019, Volume 40, 100818.
2 Journal of Financial Intermediation: “Credit default swaps and corporate bond trading,” Robert Czech, October 2021, Volume 48, 100932.
3 The Review of Economic Studies: “U.S. Monetary Policy and the Global Financial Cycle,” Silvia Miranda‐Agrippino and Hélène Rey, May 8, 2020, Volume 87, Issue 6, Pages 2754-2776.
4 Journal of International Financial Markets, Institutions and Money: “Sovereign and bank CDS spreads: Two sides of the same coin?” Davide Avino and John Cotter, September 2014, Volume 32, Pages 72–85.
5 Journal of International Money and Finance: “Transmission of the financial and sovereign debt crises to the EMU: Stock prices, CDS spreads and exchange rates,” Theoharry Grammatikos and Robert Vermeulen, April 2012, Volume 31, Issue 3, Pages 517-533.
6 Journal of Financial Intermediation: “Interbank connections, contagion and bank distress in the Great Depression,” Charles W. Calomiris, Matthew Jaremski and David C. Wheelock, July 2022, Volume 51, 100899.