Linking Bank Crises and Sovereign Defaults: Evidence from Emerging Markets

Abstract

We analyze the mechanisms through which bank and sovereign distress feed into each other, using a large sample of emerging market economies over three decades. After defining “twin crises” as events where bank crises and sovereign defaults combine, and further distinguishing between those bank crises that end up in sovereign defaults and vice versa, we study what differentiates “single” and “twin” events. Using an event analysis methodology, we document systematic differences between “single” and “twin” crises across various dimensions including the balance sheet interconnection between banks and the sovereign, banking sector characteristics, the state of public finances, the macroeconomic environment and financial openness. The importance of these characteristics in shaping the transmission of stress between banks and sovereigns is confirmed by two alternative discrete-variable multivariate approaches. We also show that “twin” crises themselves are heterogeneous events: taking into account the actual time sequence of crises that compose “twin” episodes is important for understanding their channels of transmission and economic consequences. These findings inform the flourishing theoretical literature on the mechanisms surrounding feedback loops of sovereign and bank stress.

This is a preview of subscription content, access via your institution.

Notes

  1. 1.

    See Mody and Sandri (2012), Acharya et al. (2014), Alter and Beyer (2013), Moody’s (2014), Popov and Van Horen (2013), Ongena et al. (2016) or Jordà et al. (2016) for recent empirical contributions. Relatedly, the theoretical literature is moving beyond modelling the macroeconomic effects of sovereign defaults (Mendoza and Yue 2012 or Arellano 2008) into explaining the role of financial dynamics (Malucci 2015) and banks’ balance sheets (Sosa-Padilla 2012 or Engler and Grosse-Steffen 2016).

  2. 2.

    The “twin crises” literature has mainly focused on the link between bank and balance-of-payments crises (Kaminsky and Reinhart 1999).

  3. 3.

    According to Reinhart and Rogoff (2011), (1) bank crises often lead sovereign crises, (2) external debt surges ahead of bank crises, (3) public debt increases ahead of sovereign crises and (4) short-term debt increases before debt and bank crises.

  4. 4.

    Rosas (2006) finds public bank bailouts more likely in open, rich economies or if turmoil is due to regulatory issues. Instead, electoral limits and central bank independence favor bank closure.

  5. 5.

    The fiscal costs of bank crises are well documented—see Laeven and Valencia (2012b), Feenstra and Taylor (2012), Reinhart and Rogoff (2013) or Arellano and Kocherlakota (2014).

  6. 6.

    The authorities often react to debt problems by coercing local banks to hold sovereign debt (in non-market terms), aggravating the situation in an event of default (Diaz-Cassou et al. 2008).

  7. 7.

    A number of recent papers have provided evidence on the “moral suasion” channel. De Marco and Macchiavelli (2016) present an identification strategy based on political factors, while Ongena et al. (2016) exploit fluctuations in government´s financial needs.

  8. 8.

    They further argue that the composition of fiscal stimulus affects the length of crises. There is a trade-off between boosting aggregate demand (short run) and productivity growth (long run).

  9. 9.

    As noted by Goldstein (2003), debt-to-GDP fails to take into account contingent liabilities.

  10. 10.

    De Paoli et al. (2009) find that two-thirds of sovereign defaults overlap with bank crises, and half with both bank and currency crises.

  11. 11.

    Also, Angeloni and Wolff (2012) assess the impact of sovereign exposures on banks’ performance during the euro area crisis.

  12. 12.

    These papers present a nuanced view of the effects of bond purchases by local banks. Other papers in the literature [see Andritzky (2012) or Asonuma et al. (2015)] show that these purchases can stabilize sovereign bond markets.

  13. 13.

    They find that the probability of a banking crisis conditional on a capital flow bonanza is higher than the unconditional probability in 61% of the countries they cover (for the period 1960–2007).

  14. 14.

    Obstfeld (2011) argues that “gross liabilities, especially those short-term, are what matters”.

  15. 15.

    Our sample contains only countries which experienced at least one crisis during the sample period. We have also performed the analysis with a larger sample, including 15 emerging market countries without any bank or debt crisis in our sample period, and obtained very similar results to the ones presented here.

  16. 16.

    While there are situations in which defaults may either take the form of high inflation episodes or be averted through an IMF intervention, we take a stricter view in this paper and focus on explicit defaults only.

  17. 17.

    There are twin events where both components (banking and debt crises) start the same year. In this case, we use IMF Article IV country reports, financial press and country monographs to understand the sequence of events within a twin episode.

  18. 18.

    In the case of Peru, a sequence of 1976, 1978, 1980, 1983 sovereign defaults and 1983 bank crisis is coded as a 1976 single default and a 1980-1983 twin debt-bank event. In the case of Costa Rica, a sequence of 1981 and 1984 sovereign defaults and 1987 bank crisis is coded as a 1981 single default and a 1984–1987 twin debt-bank crisis. In an earlier version of the paper, we instead code each sequence as one long twin event (i.e., 1976–1983 twin debt-bank crisis in Peru, and 1981–1987 twin debt-bank in Costa Rica) and obtain similar results (see Balteanu and Erce 2014). Finally, following Reinhart and Trebesch (2016b), the defaults experienced by the five former Yugoslavian republics of Serbia, Slovenia, Bosnia and Herzegovina, Croatia and FYR Macedonia in 1992 are not coded as such, given that they were restructurings of debt stocks that each of these countries was allocated at the breakup of the Yugoslavian state.

  19. 19.

    Arguably, a more complete measure of the banking sector´s exposure to the sovereign would also include claims on local government and public companies, which are important indicators of direct and contingent public liabilities. However, we choose to use banks’ claims on central government only due to data availability—data on claims on local/regional government and public companies are noisy and have poor coverage across many countries in our sample. We nevertheless obtain similar results when using a measure of “total claims on government” in an earlier version of this paper (Balteanu and Erce 2014).

  20. 20.

    While Claessens and Van Horen (2015) offer precise estimates of bank foreign assets in a large number of countries, their time series start in 1995 only. In a previous version of the paper (Balteanu and Erce 2014), we limit our sample to more developed emerging markets and use a measure of “total bank assets” instead, with very similar results.

  21. 21.

    The increase in banks’ holdings of public debt can be due to banks’ own decisions on risk taking or retrenching from the private sector (Broner et al. 2014), or to banks being incentivized or forced to sustain the government (Ongena et al. 2016).

  22. 22.

    It may be puzzling that growth rates are not higher than in tranquil times ahead of bank crises that feature a credit boom. Still, our findings fit into an empirical literature which does not converge on a clear pattern for output growth ahead of crises, as discussed by Bordo and Meissner (2016)’s meta-analysis of the literature on “financial and fiscal crises.”

  23. 23.

    This, in turn, may add pressure on the sovereign, given that in emerging markets debt is in a large part denominated in foreign currency.

  24. 24.

    Indeed, the DB group contains a substantial number of hyperinflations. Five out of the 16 DB crises are hyperinflations (identified as such by Hanke and Krus 2013). This implies that 31% of DB episodes are hyperinflations, which contrasts to 5% in BD crises (i.e., only one case out of 19 events), 16% in B events (i.e., eight cases out of 49 events) and 3% in D events (i.e., two cases out of 73 events).

  25. 25.

    As discussed in the previous sections, these features have been well studied in the literature.

  26. 26.

    Using a panel logit model instead delivers similar results (available upon request).

  27. 27.

    Using this methodology, Adams (2006) studies whether R&D spillovers affect the allocation of resources to research.

  28. 28.

    The explanatory variables in the model satisfy: \(E(x_{1i} \varepsilon_{1i} ) = 0\) and \(E(x_{2i} \varepsilon_{2i} ) = 0\).

  29. 29.

    We cannot use nonlinearity as a source of identification as it is done, for instance, in the Heckman model, because if the exclusion restriction fails, the linear system is unidentified.

References

  1. Abad, J. 2018. Breaking the feedback loop: Macroprudential regulation of banks’ sovereign exposures, Centro de Estudios Monetarios y Financieros, mimeo.

  2. Abbas, S.A., N. Belhocine, A. El-Ganainy, and M. Horton. 2010. A historical public debt database. IMF working paper no. 10/245.

  3. Acharya, V., and R. Rajan. 2013. Sovereign debt, government myopia and the financial sector. Review of Financial Studies 26(6): 1526–1560.

    Article  Google Scholar 

  4. Acharya, V., I. Drechsler, and P. Schnabl. 2014. A pyrrhic victory: Bank bailouts and sovereign credit risk. Journal of Finance 69(6): 2689–2739.

    Article  Google Scholar 

  5. Acharya, V. V., and S. Steffen. 2015. The “Greatest” carry trade ever? Understanding Eurozone bank risks. Journal of Financial Economics 115(2): 215–236.

  6. Adams, J.D. 2006. Learning, internal research and spillovers. The Economic of Innovation and New Technology 15: 5–36.

    Article  Google Scholar 

  7. Alessandri, P., and A. Haldane. 2009. Banking on the state, mimeo. Bank of England.

  8. Alter, A., and A. Beyer. 2013. The dynamics of spillover effects during the European sovereign debt turmoil. Journal of Banking and Finance 42: 134–153.

    Article  Google Scholar 

  9. Andritzky, J.R. 2012. Government bonds and their investors: What are the facts and do they matter? IMF working paper no. 12/158.

  10. Angeloni, C., and W. Wolff. 2012. Are banks affected by their holdings of government debt? Bruegel working paper no. 2012/07.

  11. Arellano, C. 2008. Default risk and income fluctuations in emerging economies. American Economic Review 98(3): 690–712.

    Article  Google Scholar 

  12. Arellano, C., and N.R. Kocherlakota. 2014. Internal debt crises and sovereign defaults. Journal of Monetary Economics 68(S): 68–80.

    Article  Google Scholar 

  13. Asonuma, T., S.A. Bakhache, and H. Hesse. 2015. Is banks’ home bias good or bad for public debt sustainability? IMF Working Papers 15/44.

  14. Baldacci, E., and S. Gupta. 2009. Fiscal expansions: What works. Finance and Development 46(4): 35–37.

    Google Scholar 

  15. Balteanu, I., and A. Erce. 2014. Bank crises and sovereign defaults in emerging markets: Exploring the links. Bank of Spain working paper no. 1414.

  16. Battistini, N., M. Pagano, and S. Simonelli. 2014. Systemic risk, sovereign yields and bank exposure in the euro crisis. Economic Policy April: 203–251.

    Article  Google Scholar 

  17. Bianchi, J., and E. Mendoza. 2018. Optimal time-consistent macroprudential policy. Journal of Political Economy 126(2): 588–634.

    Article  Google Scholar 

  18. Bordo, M., and C. Meissner. 2016. Fiscal and financial crises. NBER working paper 22059.

  19. Borensztein, E., and U. Panizza. 2009. The costs of sovereign default. IMF Staff Papers 56(4): 683–741.

    Article  Google Scholar 

  20. Broner, F., T. Didier, A. Erce, and S. Schmukler. 2013. Gross capital flows: Dynamics and crises. Journal of Monetary Economics 60(1): 113–133.

    Article  Google Scholar 

  21. Broner, F., A. Erce, A. Martin, and J. Ventura. 2014. Sovereign debt markets in turbulent times: Creditor discrimination and crowding out. Journal of Monetary Economics 61(C): 114–142.

    Article  Google Scholar 

  22. Brunnermeier, M., and Y. Sannikov. 2014. A macroeconomic model with a financial sector. American Economic Review 104(2): 379–421.

    Article  Google Scholar 

  23. Brutti, F. 2010. Legal enforcement, public supply of liquidity and sovereign risk. Institute for Empirical Research in Economics, University of Zurich working paper no. 464.

  24. Candelon, B., and F.C. Palm. 2010. Banking and debt crises in Europe. The dangerous liaisons? De Economist 158(1): 81–99.

    Article  Google Scholar 

  25. Caprio, G. Jr., and P. Honohan. 2008. Banking crises. Institute for international integration studies discussion paper no. 242.

  26. Cavallo, E., and A. Izquierdo. 2009. Dealing with an international credit crunch: Policy responses to sudden stops in Latin America, Inter-American Development Bank, mimeo.

  27. Cesa-Bianchi, A, A. Ferrero, and A. Rebucci. 2017. International credit cycles. NBER working paper no. 23841.

  28. Chari, V.V., A. Dovis, and P. Kehoe. 2016. On the optimality of financial repression, federal reserve bank of Minneapolis, Research Department staff report 1000.

  29. Chinn, M.D., and H. Ito. 2006. What matters for financial development? Capital controls, institutions, and interactions. Journal of Development Economics 81(1): 163–192.

    Article  Google Scholar 

  30. Claessens, S., and N. Van Horen. 2015. The impact of the global financial crisis on banking globalization. IMF Economic Review 63(4): 868–918.

    Article  Google Scholar 

  31. Corsetti, G., and L. Dedola. 2016. The mystery of the printing press: Self-fulfilling debt crises and monetary sovereignty. CEPR discussion paper no. 9358.

  32. Darracq-Pariès, M., L. Maurin, and D. Moccero. 2014. Financial conditions index and credit supply shocks for the euro area. ECB working paper no. 1644.

  33. Das, U., M. Papaioannou, and C. Trebesch. 2009. Sovereign default risk and private sector access to capital in emerging markets. In Debt relief and beyond: Lessons learned and challenges ahead, ed. C.A. Primo Braga and D. Dömeland. Washington: World Bank.

    Google Scholar 

  34. De Marco, F., and M. Macchiavelli. 2016. The political origin of home bias: The case of Europe, Federal Reserve Board. Finance and economics discussion papers 060-2016.

  35. De Paoli, B., G. Hoggarth, and V. Saporta. 2009. Output costs of sovereign crises: Some empirical estimates. Bank of England working paper no. 362.

  36. Diaz-Alejandro, C. 1985. Good-bye financial repression, hello financial crash. Journal of Development Economics 19(1–2): 1–24.

    Article  Google Scholar 

  37. Diaz-Cassou, J., A. Erce, and J. Vazquez. 2008. Recent episodes of sovereign debt restructuring: A case-study approach. Bank of Spain occasional document no. 0804.

  38. Drechsler, I., T. Drechsler, D. Marques-Ibanez, and P. Schnabl. 2016. Who borrows from the lender of last resort? Journal of Finance 71(5): 1933–1974.

    Article  Google Scholar 

  39. Engler, P., and C. Grosse-Steffen. 2016. Sovereign risk, interbank freezes and aggregate fluctuations. European Economic Review 87: 34–61.

    Article  Google Scholar 

  40. Farhi, E., and J. Tirole. 2018. Deadly embrace: Sovereign and financial balance sheets doom loops. Review of Economic Studies 85(3): 1781–1823.

    Article  Google Scholar 

  41. Feenstra, R.C., and A.M. Taylor. 2012. International economics, 2nd ed. New York: Worth Publishers.

    Google Scholar 

  42. Forni, L., G. Palomba, J. Pereira, and C. Richmond. 2016. Sovereign debt restructuring and growth. IMF working paper 16/147.

  43. Gennaioli, N., A. Martin, and S. Rossi. 2014b. Banks, government bonds and default: What do the data say? IMF working paper no. 14/120.

  44. Gennaioli, N., A. Martin, and S. Rossi. 2014a. Sovereign default, domestic banks and financial institutions. Journal of Finance 69(2): 819–866.

    Article  Google Scholar 

  45. Goldstein, M. 2003. Debt sustainability, Brazil and the IMF. Peterson Institute working paper no. WP03-1.

  46. Gourinchas, P.O., and M. Obstfeld. 2012. Stories of the twentieth century for the twenty-first. American Economic Journal: Macroeconomics 4(1): 226–265.

    Google Scholar 

  47. Gray, D., and A. Jobst. 2013. Systemic contingent claims analysis—estimating market-implied systemic risk. IMF working paper no. 13/54.

  48. Gray, D., M. Gross, J. Paredes, and M. Sydow. 2013. Modelling banking, sovereign and macro risk in a CCA global VAR. IMF working paper no. 13/218.

  49. Greene, W.H. 2012. Econometric analysis, 7th ed. Upper Saddle River: Prentice Hall.

    Google Scholar 

  50. Hanke, S.H., and N. Krus. 2013. World hyperinflations. In The handbook of major events in economic history, ed. R. Parker and R. Whaples. London: Routledge.

    Google Scholar 

  51. Honohan, P. 2008. Risk management and the costs of the banking crisis. National Institute Economic Review 206(1): 15–24.

    Article  Google Scholar 

  52. IMF. 2002. Sovereign debt restructurings and the domestic economy experience in four recent cases. Policy Development and Review Department.

  53. Jácome, L. I. 2008. Central bank involvement in banking crises in latin America. IMF Working Papers 08(135): 1.

    Article  Google Scholar 

  54. Jordà, Ò., M. Schularick, and A. Taylor. 2016. Sovereigns versus banks: Credit, crises and consequences. Journal of the European Economic Association 14: 45–79.

    Article  Google Scholar 

  55. Kaminsky, G., and C. Reinhart. 1999. The twin crises: The causes of banking and balance-of-payments problems. American Economic Review 89(3): 473–500.

    Article  Google Scholar 

  56. Kollmann, R., W. Roeger, and J. in’t Veld. 2012. Fiscal policy in a financial crisis: Standard policy vs. bank rescue measures. American Economic Review 102(3): 77–81.

    Article  Google Scholar 

  57. Laeven, L., and F. Valencia. 2012b. Systemic banking crises database: An update. IMF working paper no. 12/163.

  58. Laeven, L., and F. Valencia. 2012a. The use of blanket guarantees in banking crises. Journal of International Money and Finance 31(5): 1220–1248.

    Article  Google Scholar 

  59. Laeven, L., and F. Valencia. 2013. The real effects of financial sector interventions during crises. Journal of Money, Credit and Banking 45(1): 147–177.

    Article  Google Scholar 

  60. Livshits, I., and K. Schoors. 2009. Sovereign default and banking. BEROC working paper series no. 005.

  61. Malucci, E. 2015. Domestic debt and sovereign defaults. International finance discussion papers no. 1153, Board of Governors.

  62. Mendoza, E., and V. Yue. 2012. A general equilibrium model of sovereign default and business cycles. Quarterly Journal of Economics 127: 889–946.

    Article  Google Scholar 

  63. Mitchell, B.R. 2007. International historical statistics: 1750–2005. London: Palgrave MacMillan.

    Google Scholar 

  64. Mody, A., and D. Sandri. 2012. The Eurozone crisis: How banks came to be joined at the hip. Economic Policy 27(70): 199–230.

    Article  Google Scholar 

  65. Moody’s. 2011. Sovereign default and recovery rates, 1983–2011, mimeo.

  66. Moody’s. 2014. European sovereign debt and banking crises: Contagion, spillovers and causality. Moody’s investors service, credit policy.

  67. Noyer, C.. 2010. Sovereign crisis, risk contagion and the response of the central bank, mimeo.

  68. Obstfeld, M. 2011. Financial flows, financial crises, and global imbalances. Journal of International Money and Finance 31: 469–480.

    Article  Google Scholar 

  69. Ongena, S., A. Popov, and N. Van Horen. 2016. The invisible hand of the government: Moral suasion during the European sovereign debt crisis. CEPR discussion papers 11153.

  70. Popov, A., and N. Van Horen. 2013. The impact of sovereign debt exposure on bank lending: Evidence from the European debt crisis. DNB working paper no. 382.

  71. Reinhart, C.M., and K.S. Rogoff. 2008. This time is different: A panoramic view of eight centuries of financial crises. NBER working paper no. 13882.

  72. Reinhart, C.M., and V. Reinhart. 2009. Fiscal stimulus for debt intolerant countries? MPRA paper no. 16937.

  73. Reinhart, C.M. 2012. The return of financial repression. CEPR discussion paper no. 8947.

  74. Reinhart, C.M., and K.S. Rogoff. 2009. The aftermath of financial crises. American Economic Review 99(2): 466–472.

    Article  Google Scholar 

  75. Reinhart, C.M., and K.S. Rogoff. 2011. From financial crash to debt crisis. American Economic Review 101(5): 1676–1706.

    Article  Google Scholar 

  76. Reinhart, C.M., and K.S. Rogoff. 2013. Banking crises: An equal opportunity menace. Journal of Banking and Finance 37(11): 4557–4573.

    Article  Google Scholar 

  77. Reinhart, C.M., and M.B. Sbrancia. 2015. The liquidation of government debt. Economic Policy 30(82): 291–333.

    Article  Google Scholar 

  78. Reinhart, C.M., and C. Trebesch. 2016a. The international monetary fund: 70 years of reinvention. Journal of Economic Perspectives 30(1): 3–28.

    Article  Google Scholar 

  79. Reinhart, C.M., and C. Trebesch. 2016b. Sovereign debt relief and its aftermath. Journal of the European Economic Association 14: 215–251.

    Article  Google Scholar 

  80. Rosas, G. 2006. Bagehot or bailout? An analysis of government responses to banking crises. American Journal of Political Science 50(1): 175–191.

    Article  Google Scholar 

  81. Sosa-Padilla, C. 2012. Sovereign defaults and banking crises. MPRA Paper 41074, University Library of Munich, Germany.

  82. Standard and Poor’s. 2006. Sovereign defaults At 26-year low, to show little change in 2007, mimeo.

  83. Van Rixtel, A., and G. Gasperini. 2013. Financial crises and bank funding: Recent experience in the euro area. BIS working paper no. 40.

Download references

Acknowledgements

We thank M. Bussière, G. Cheng, J. Frost, J. Jimeno, E. Kharroubi, G. Perez-Quirós, R. Portes, P. Rabanal, two anonymous referees and seminar participants at European Stability Mechanism, 2014 Emerging Market Finance Workshop, Bank of Spain, Bank for International Settlements, Workshop for the Sixth High-Level Seminar of the Euro-system and Latin American Central Banks, Tenth Emerging Markets Workshop, CEMLA Meetings, and 2012 European Summer Symposium in International Macroeconomics, for their comments, and K. Siskind for excellent editorial assistance. J. Estefania, L. Fernandez, I. Gramatki, M. Gomez, L. Sanchez and B. Urquizu provided excellent research assistance.

Author information

Affiliations

Authors

Corresponding author

Correspondence to Irina Balteanu.

Electronic supplementary material

Below is the link to the electronic supplementary material.

Supplementary material 1 (ZIP 619 kb)

Appendices

Appendix 1: Crises and Variables

See Tables 1 and 2.

Table 1 “Single” and “twin” crisis events.
Table 2 Variables: definitions and sources

Appendix 2: Fiscal and Output Costs of Banking Crises

See Table 3.

Table 3 Fiscal and output costs of banking crises.

Appendix 3: Figures

Bank (B) Versus Bank-To-Debt (BD) Crises

figurea
figureb

Debt (D) Versus Debt-To-Bank (DB) Crises

figurec
figured

Note: Figures 1–26 plot the evolution of the variables of interest with respect to “non-crisis” times, in a window of −/+ 3 years around the different types of crisis events (where T is the initial year of the crisis). As discussed in Sect. 4, the figures show the economic importance of the coefficients reported in Tables 416 in Appendix 4, obtained by multiplying these coefficients by the median one standard deviation of the non-standardized value of the dependent variable across countries with the same type of crises. The 90% confidence bands are shown in fine lines.

Appendix 4: Econometric Results—Event Analyses

See Tables 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, 15 and 16.

Table 4 Credit from the central bank (% bank domestic assets)
Table 5 Bank domestic assets (% GDP)
Table 6 Claims on government (% bank domestic assets)
Table 7 Credit to the private sector (% GDP)
Table 8 Budget expenditures (% GDP)
Table 9 Budget balance (% GDP)
Table 10 Public debt (% GDP)
Table 11 Real GDP growth (%)
Table 12 Inflation rate (%)
Table 13 Total capital inflows (% GDP)
Table 14 Short-term debt in total foreign debt (%)
Table 15 Real effective exchange rate (index, 2000 = 100)
Table 16 Chinn–Ito index of capital account liberalization (%)

Appendix 5: Econometric Results (II): Multivariate Approaches

See Tables 17 and 18.

Table 17 Multinomial logit regressions
Table 18 Bivariate ordered probit regressions

Rights and permissions

Reprints and Permissions

About this article

Verify currency and authenticity via CrossMark

Cite this article

Balteanu, I., Erce, A. Linking Bank Crises and Sovereign Defaults: Evidence from Emerging Markets. IMF Econ Rev 66, 617–664 (2018). https://doi.org/10.1057/s41308-018-0066-4

Download citation

JEL Classification

  • E44
  • F34
  • G01
  • H63